Market updates

A few weeks ago Bank of America Merrill Lynch’s CEO, Brian Moynihan, said that loan losses were not coming through as thick or as fast as he would normally expect for a recession, in particular a recession of this magnitude.

There have been two topics concerning the yield curve in the press over the last few days, which we think merit closer attention. As regular readers will know, the US yield curve in particular is closely followed by market participants and can dictate a lot of what happens in fixed income markets globally.

Markets opened today to the news that German Chancellor, Angela Merkel, and French President, Emmanuel Macron, had reached an agreement to support the launch of a €500bn support package to aid the European Union’s recovery from the coronavirus outbreak, which has devastated large parts of the continent.

European ABS primary markets re-opened late last week with the pricing of the first publicly syndicated deal since recent events took hold of global financial markets. Long-standing issuer BMW priced a 1.6-year AAA German Auto ABS deal at three-month Euribor +40bp, having increased the size of the deal to €700m and finishing around 1.7x oversubscribed.

Thursday saw the reopening of the bond market for bank Additional Tier 1 (AT1) debt, more colloquially known as ‘Coco’ bonds.

A lot has been made of the recent recovery in equity markets, especially in the US, given the obvious underlying weaknesses in the economy. It is quite clear to us the economic fundamentals do not justify such high valuations in risk assets, but despite being a serious consideration in our assessment, there is often much more to valuations than just fundamentals.

One of the big support mechanisms for the UK economy during this pandemic has been the availability of grants and corporate loans via the banking system, aided by unlimited liquidity from the central bank.

After six weeks of no supply, the market somewhat surprisingly reopened with three new issue CLOs being priced last week and a new one already on the way. We are aware of many loan warehouses that need to be cleared, and bankers (or rather their risk managers) are no doubt keen for CLO managers to refinance leveraged loans into a CLO.

The list of policy actions from the major central banks keeps getting longer, and today the Bank of Japan has added the purchase of “as many Japanese government bonds (JGBs) as necessary” so as to keep the 10-year rate at around zero percent.

We engage with Santander as a debt issuer across many jurisdictions and various fixed income products, and we have had mixed views on the bank’s behaviour in recent years following a controversial approach to a 2018 AT1 refinancing and the exercise of an early call in a Spanish ABS deal in 2019. On both these occasions, we felt bondholders were treated poorly and this was reflected in our ESG analysis of the issuer.

Although we are very much still in the grip of COVID-19’s impact, it has now been a month since the equity market’s trough and now would seem an opportune time to dissect some of the price action that preceded the unparalleled market turmoil in March.

The European high yield sector has seen a sharp correction from its highs earlier this year, with the Crossover index moving from a tight of 203bp in January to an intraday wide of 730p on March 18 (by this morning it had also seen a retracement of around 50% to 470bp).

When the Fed announced last month that it would be buying investment grade corporate bonds, it was said to have thrown the kitchen sink at the coronavirus problem. After this latest move, there are holes where the kitchen cabinets used to be.

It has been a positive sign for us that despite lockdowns being enforced in most of the major economies around the world, in the last two weeks several issuers have managed to successfully raise new debt via the primary market.

After a period of material weakness in spreads and general market stress, the common ingredient to recent corporate bond spread stability and subsequent strength has been the resurgence of the primary market.

Having started the year with low yields and tight spreads, fixed income markets had the most brutal month I can recall in March and have been repriced in the most aggressive manner imaginable. The dust does appear to have settled and a more balanced market without ‘fire sale’ pressure has returned, so we thought it was worth recapping where we are today and sharing some thoughts for the journey ahead.

As a manager that invests across the full spectrum of fixed income, we are constantly monitoring the relative value of the different opportunity sets that we cover. Given the fast moving prices we have witnessed recently, and with different asset classes and ratings moving at different times, this analysis can become increasingly valuable.

In response to the exceptional circumstances brought about by Covid-19, the Prudential Regulation Authority (PRA) at the Bank of England has written to UK banks asking them to ‘consider’ appropriate action regarding the payment, accrual and vesting of variable remuneration (i.e. bonuses) for senior staff, together with any dividend payments or share buyback plans.

In the last two weeks we’ve looked at how CLOs behaved during the global financial crisis, and we’ve stress tested a current CLO with GFC-like defaults to see where individual tranches would start to take a loss in that scenario. Keeping in mind the rule that the third in any trilogy is usually either the best or the worst, let’s hope this third instalment is more Toy Story 3 than Tokyo Drift.

With central banks and governments pumping huge amounts of funding into their domestic economies, they are obviously very keen that companies act with prudence and look after their surplus cash sparingly, by cutting back on distributions such as dividend payments and any share buyback plans.

At any other time, record issuance and record outflows in US investment grade would each be worthy of attention. Given the havoc COVID-19 has wreaked in recent weeks, it would be tempting to write off these milestones occurring in parallel last week as merely the latest quirk of an unprecedented period for bond markets, but the reasons behind this apparent sentiment split are worth keeping an eye on.

After a considerable period of zero activity new issue bond markets have reopened this week with a flurry of deals in the US and now in Europe. As usual it has been frequent high quality borrowers reopening the marketplace, and they have done so with confidence from their syndicate bankers that attractive pricing will result in successful transactions.

Clearly this shock/stress test is a severe scenario, but given the uncertainties that COVID-19 has thrown our way, as debt investors we would rather be overly conservative.

Some of the panic selling has also abated as investors are gradually building their cash piles to desirable levels. However, we are still a long way away from normal bond markets.