Inflation watch continues
Breakeven rates rise
Morning Stanley first of big 6 to launch bonds after third- quarter results
European Union launches record breaking green bond
French bank launches bond with rare covenant structure
More bad news for bond investors and shareholders from China
South Korea goes green
We are entering into a period of challenge for bond investors. With inflation looking to rise, possible interest rate increases, higher oil and energy prices, persistent supply side bottlenecks and strong wage dynamics, bond portfolios, if not carefully managed, could suffer. We have been discussing inflationary pressures for months and been wary of global central banks downplaying the possibility of increases. This week we have seen one leading UK bond fund manager announcing portfolio losses of £2.1bn, in just three months! The fund manager had significant holdings in the China Evergrande Group. We have never been large investors in Chinese bonds, nor emerging market debt in general for that matter, thereby protecting our clients’ portfolios.
We believe there continues to be very attractive bonds available in safe companies that can give good yields. Investors are still putting up significant amounts of money for any and all the new issues appearing in the market. We also take comfort from the very low default rates, which are at historically low levels. The market is still vibrant enough to give our clients good safe returns.
U.S. inflation expectations vary enormously. Inflation was 5.4% in the 12 months to September, a 13 year high. Although, at the moment anyway, the Fed believes that it will be back down to 2.2% next year. The central bank looks likely to reduce its $120bn a month bond buying programme in the coming months. It is also thought that the Fed will begin raising interest rates from their current near-zero levels in December 2022 - earlier than previously anticipated - in large part to the higher inflation expectations. We believe rate rises could be seen even sooner.
Investors are preparing for a volatile ride amid the expectations that the Federal Reserve will begin to reduce its stimulus this year after a rise in inflation. With higher oil and other commodity prices investors have been demanding higher yields. The price of Brent oil has now passed $85 a barrel mark for the first time since late 2018 and natural gas rising to an eight year peak.
Policy maker Silvana Tenreyro at the Bank of England (BOE) suggested yesterday that a rise in interest rates to combat a temporary rise in inflation risks being ‘self-defeating’. Nevertheless it is thought the BOE could start raising its rate by the end of this year, possibly to .25% from its current .01%. It is also thought the bank will increase its main rate to 1% by the end of 2022.
We have the tools in our toolbox to shield investors from downside risks from rising inflation. These include switching to companies with higher credit ratings, reducing durations and perhaps moving into inflation protected bonds. We have the ability, expertise, and conviction to move fast and decisively if needed.
Rising breakeven rates
We are monitoring the rise in the level of international breakeven rates. With inflation rising, the breakeven inflation rate is a predictive measurement that helps investors gauge how certain investments are likely to perform if high inflation comes to town. Breakeven inflation rates are calculated by comparing the yield of an index-linked bond with that of a fixed rate bond of the same maturity. The difference between as to how the two have performed represents the rate that inflation would have to be to ‘break-even’ between buying fixed or index-linked bonds. The interesting 10 year breakeven chart below shows, from the 1990’s, what the expected inflation will be in the next 10 years, on average.
We are carefully watching these breakeven rates and stand ready to start buying floating rate notes for protection, as we have done in the past.
Chart of the 10-year U.S. Treasury breakeven rate
Morgan Stanley issues bonds after announcing blowout third- quarter results
Morgan Stanley (MS) is the first of the six biggest U.S. banks to sell fresh high-grade bonds following their third-quarter earnings, with profits rising 36%. The bank took advantage of favourable sales conditions – its share rising 47% so far this year. Morgan Stanley raised $5bn with the issue of 4 and long 10-year fixed to floating bonds. The 4-year bond has a coupon of 1.164% and the 10-year 2.511% MS, at the senior level of these bonds is rated A1/BBB+/A, stable/positive/stable. During the highly successful bookbuild, MS was able to tighten the spread on the bonds by 13 to 15bps.These bonds performed well after launch with both tightening further in the secondary market.
Record European Union green bond
Earlier this week the European Union launched a jumbo €12bn green bond. Investors in this green bond, which is backed by EU member states and the EU budget, were not put off by the bond’s 15-year maturity as they offered a record €135bn for it. The bond has a coupon of 0.4% and a February 2037 maturity. The bond is rated Aaa/AA/AAA stable/positive/stable. Given the success of the bookbuild the bond has unsurprisingly done well, issued on a spread of +31.6bps it now trades at +29bps, equating to a 1.5 price premium.
The proceeds will be used, under the NextGenerationEU green bond framework, for nine broad categories of expenditure, including energy efficiency, clean energy and climate change adaptation.
French bank new issue with rare covenant terms
French bank BPCE SA revived an unusual type of bond that can trigger an automatic write-down, showing that appetite for risky debt of all types is still in high demand. The bank has sold two euro denominated Tier 2 CoCo bonds raising €1.75bn, which come with a clause saying that if a measure of financial strength falls below a certain level, a quarter of the bond’s value is wiped out. That kind of write-down trigger is more commonly associated with junior debt known as Additional Tier 1 and only been used by very few banks over the years.
The covenant terms state that, under certain conditions, if the CET1 Capital Ratio falls below 7% then 25% of the bond’s nominal will be permanently written down. Investors were not put off by these covenants. With the BPCE’s current CET1 ratio around 15.6%, investors were happy with the terms and during the book-build both tranches tighten 35bps from first thought and a €4.725bn book was created. The two bonds are a €900m 20.25-year with a call in 5.25-years and a coupon of 1.5% and a €850m 25-year with a call in 10-years and a coupon of 2.125%. At senior level BPCE is rated A1/A/A+ stable/stable/negative and at the subordinated level of these bonds they are rated Baa3/BBB/A-. Both bonds, which were launched on a spreads of +214 and +242bps respectively over Treasuries are now trading better at +204bps and +237bps.
The issuing brokers were determined to only allow professional and institutional investors buy these bonds as not only the minimum purchase size was $200k but after that it can only be bought in $200k lots.
More cracked China
More negative news from China property sector as Fantasia Holdings Group has failed to repay their bond which was due last week as well as failing to repay a $100m loan to Country Garden. Fantasia’s total liabilities were $12.9bn as of 30th June according to the company’s first-half report, compared with $304.5bn for ChinaEvergrande.
China Evergrande did take a small step in the right direction with the sale of a stake in a joint venture as a cash crunch deepens at the struggling property giant. A unit of Evergrande Real Estate Group plans to sell a 40% stake in a furnishings joint venture to Qumei Home Furnishings Group for the equivalent of $11m. Sadly though it didn’t make a much of a dent in Evergrande’s more than $300bn liabilities. The developer’s shares and those of its property services unit, have been suspended from Hong Kong trading since last week. To reiterate - Naisbitt King Asset Management has never had exposure to China Evergrande and currently have almost zero holdings in any other Chinese companies. As I have said before, the Country Garden Holdings property company bond that we sold in September at a price of around 99.50 is now trading at 85.00, having recovered from a low of 82.00.
While contagion risk over Evergrande is deepening in China causing Chinese high yield debt to skyrocket to 20% but the same can’t be said of other debt markets.
Apart from China, other countries we are currently wary of include Indonesia, Thailand, Turkey, and South Africa as well as some in Latin America.
Three South Korean green bonds hit the market
Last week South Korea launched a very successful 10-year bond its first in a year. The $500m 10-year sovereign bond for the East Asian country managed to gather a great orderbook of $2.1bn. We heard that 60% of the orders came from EMEA (Europe. Middle East and Africa). South Korea quicky followed their dollar deal with an equally popular euro denominated €700m 5-year green covered bond which had a zero percent coupon with 90% of orders coming from EMEA. Both bonds have performed extremely well since launch.
South Korea is still very well rated at Aa2/AA/AA- all stable, ratings at have remained unchanged for many years.
This month we have seen other green bonds emanating from South Korea. Export-ImportBank of Korea and Kookmin Bank also launched environmental bonds.
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