As we reach the halfway stage of the year with have seen the fixed income markets perform far better than the same period in the last couple of years. By the end of the first half of last year PIMCO’s Total Return Fund was down 12.21%, however this year it’s up 2.68% (see Chart 1). In fact 2022 was the worst year on record for bonds which of course mainly due to Central banks determinedly, and quickly, raising interest rates which hit bond prices.
With global inflation still proving sticky Central banks are still on red alert to continue rate increases. And even as we see a chance for two more rate increases in the months ahead from the Federal Reserve (see Chart 2) the US economy is expected to hold up well, unlike Europe’s which is showing signs of stalling. There is a realisation setting in that the Fed, the ECB and the Bank of England aren’t going to be cutting interest rates by the end of year. The theme of ‘higher for longer’ is echoing around the market. Despite this the underlying growth outlook persists with solid levels of business investment. Corporate defaults rates continue to be low. Although higher rates look here to stay for the moment the economic outlook is growing less uncertain and the swings in the bond markets less severe.
Traders see another quarter-point hike by the Fed later this month as likely. Its policy rate is seen peaking this year range at 5.25% to 5.5%, before the US central bank pushes rates down to around 4.25% by December 2024, a level that’s still considered high enough to slow economic growth. The 10-year Treasury yield ended the last month at a yield of 3.84% but is expected to fall to 3.25% by year end. With the yield curve still severely inverted the 2-year Treasury bond now yields as much as 4.90%. The 2–10-year yield inversion at 1.1% is the steepest in over 30 years. It’s far from certain in this case but a yield curve inversion is usually seen as an indication of economic recession. Gilts also have an inverted curve with the 10-year ending last month at 4.38% and the 2-year at 5.23%. Last month the Bank of England surprised the market by raising rates by 50bps to 5%, rather than the 25bps expected. It is now thought that the UK could even see a 6% base rate this year.
New issue volumes maintained
The primary market continues to be open for all and there seems no let up the appetite for investors in all sectors. The high grade new issuance volume last month of $91bn was in line with expectations. Looking ahead, the dollar market is expecting $75bn in this month. In July 2021 and 2022, sales were at $80.8bn and $87.4bn, respectively. The high yield market is also faring well with year to date volumes at $92.7bn, beating last year total by $25.6bn.
The death of the AT1 bond structure has been greatly exaggerated
A couple of weeks ago Spain’s Banco Bilbao Vizcaya (BBVA) launched a €1bn junior subordinated AT1 Contingent Convertible ‘CoCo’ bond. With a coupon of 8.375% until its call date in December 2028 the bond proved popular with investors with an orderbook above €3bn. To demonstrate the significance of the new issue to investors, another BBVA CoCo, with a coupon of 5.875% and a call in September this year, that was trading at a price of 90.00 in March is now trading around 99.00 as investors expect the bond will now be redeemed on time. This Junior bond is rated Ba2/BB, both stable. Since launching the bond on a spread of +554.40bps vs. Mid Swaps the bond has tightened.
Thames Water drowns in debt
The largest water supplier in Britain continues to talk to the UK government about its very survival. Talks between water regulator Ofwat, the Department for Environment, Food and Rural Affairs and the UK Treasury about bringing the utility company into a so-called special administration regime. Thames Water said it will be working with shareholders to raise more equity. The company maintained it has a strong liquidity position.
Thames Water provides water services for 15 million people in London and the South East. Its CEO, Sarah Bentley stepped down with immediate effect a week ago amid concerns over the financial stability of the firm. About £14bn ($17.8bn) of debt at the utility’s operating companies have been put on watch negative. The firm’s senior class A debt and its more junior class B liabilities are currently rated BBB and BB+ respectively. Over the weekend Thames Water shareholders said they are planning to inject £1bn into the business in an attempt to stop it from falling into administration. Thames Water’s bonds fell steeply last week. Bonds maturing in April 2027, issued out of Thames Water Utilities Finance Plc were down to 90.5 cents on the euro on Friday from about par on Tuesday. Its likely to be a choppy for Thames Water stakeholders and bondholders for some time to come.
We do not have any holdings in Thames Water bonds in any portfolios.
Regards,
Trevor Cooper
Currency and Commodity Movements
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