Hello, and welcome to the first Naisbitt King quarterly report analysing events of the past three-months. In this newsletter we will look at the biggest stories moving bond markets, idiosyncratic events and potential bond market catalysts.
This issue will cover:
The Fed surprised the market with a 50bp cut to interest rates;
Geopolitical tensions are mounting, but markets seem ignorant;
Will the Beijing's economic bazooka break the state of economic malaise; and,
Global Additional Tier 1 regulation is diverging in the wake of the Credit Suisse write down.
This quarter in numbers
The tables provide a snapshot of credit market health for both Investment Grade (IG) and High Yield (HY). We present both total primary market volume being added to the reference indices and net increase in Index size due to calls and maturities.
Total primary market volumes have risen sequentially and year-over-year for both IG and HY. Though the start of year issue rush is yet to be overcome. Total US IG corporate bond issuance (wider than index eligible bonds) is up 34% year on year, while total US HY corporate bond issuance is up 85% year on year.
New Issues | 2024 Q3 | 2024 Q2 | 2024 Q1 | 2023 Q4 | 2023 Q3 |
|---|---|---|---|---|---|
IG Gross Issuance (mn) | 425,408.2 | 356,048.3 | 539,917.0 | 210,199.3 | 293,497.9 |
IG Net Issuance (mn) | 164,427.4 | 16,784.2 | 253,829.0 | 15,130.3 | 56,546.5 |
HY Gross Issuance (mn) | 84,175.7 | 80,735.0 | 89,610.7 | 47,444.2 | 42,530.5 |
HY Net Issuance (mn) | 23,972.8 | 11,644.8 | 27,786.6 | 6,416.3 | 13,970.3 |
Default rates moderated over all measures in a sign of positive corporate health for companies at the lower end of the credit quality spectrum.
Default Rates | 2024 Q3 | 2024 Q2 | 2024 Q1 | 2023 Q4 | 2023 Q3 |
|---|---|---|---|---|---|
Company Default Count | 35 | 46 | 62 | 61 | 48 |
Bond Default Count | 49 | 72 | 116 | 121 | 101 |
Nominal Value (mn) | 21,054.90 | 31,104.00 | 57,044.90 | 65,874.90 | 61,732.40 |
Nominal Value (% of Index) | 1.5% | 2.2% | 4.0% | 4.5% | 4.2% |
Reference indices are the Bloomberg Corporate Index - LUACTRUU - and the Bloomberg Corporate High Yield Index - LF98TRUU.
Performance
Credit markets have proved resilient year-to-date, as high yield bonds have returned 8.5% and investment grade 6.0%.
The bulk of index returns came during the third quarter despite market shocks in the first week of August and September, respectively. High yield has outperformed investment grade as corporate bond spreads have compressed towards their lowest levels since 2021.
Time for a Fed victory lap?
September saw the first rate cut of the Federal Reserve's easing cycle with market pricing the most uncertain about the size of policy change since 2008, see chart below. As we know the Fed delivered a jumbo 50bp cut and, during his press conference, Jerome Powell suggested that the Fed may have cut rates at its previous meeting in July had the June inflation data been available. We therefore read the 50bp cut as a catch up on where the FOMC believes policy rates should be rather due to concerns about the economy.
Beginning an easing cycle with a 50bp cut usually signals deteriorating economic conditions and is cause for market concern. However, it appears the Fed may be able to coordinate a soft landing - managing to successfully control inflation whilst not tipping the economy into a recession. Inflation has fallen back towards the target level, although has yet to reach 2%, and there has been no evidence of a shock to the labour market. Data released in the weeks after the Fed's cut show unemployment fell back to 4.1% in September from a high of 4.3% in July and 254,000 jobs were added to US payrolls in September, over 100,000 more than expected by economists. In addition, the Fed's preferred inflation measure, personal consumption expenditures (PCE) fell to 2.2% in September. In recent days this has prompted questions of whether the Fed will even need to cut rates again this year.
Short term expectations are volatile given little forward guidance by the Fed so are liable to reprice at each data release. However, we remain confident in further monetary easing for the world's largest economy, which will provide capital appreciation for the bond market. As the Fed progresses on its easing cycle, fixed income investors have the opportunity for sizeable gain by positioning strategically along the curve. It is our view that yields in the belly- and longer-end of the curve will fall. To take capitalise from this thesis we have increased duration of our portfolios, with a mixture of longer an mid-duration assets. Duration volatility means investors are rewarded more for an equal fall in yield on a 30-year bond over a 2-year.
Geopolitical Tensions Simmering
Conflict in the Middle East became more widespread as Israel began to target the Iranian backed Hezbollah group in Lebanon, drawing Iran to the fringes of the conflict and Israel has threatened to fire missiles at Iranian oil or nuclear sites. Despite this, oil prices do not reflect a severe escalation in hostilities that risk involving western nations. Brent crude is trading below $80 per barrel and though volatility is up compared to recent history the pandemic and Russian invasion of Ukraine remain more notable movements on the chart below.
A surge in oil prices is a tail risk that could stoke cost pressures for corporates fuelling price increases and another round of inflation. We do not have reason to believe an inflation resurgence is imminent, as other supply side constraints such longer shipping routes to avoid Houthi attacks in the Red Sea have not shown up on inflation reports. Dock worker strikes appear to have been averted and though 61.5% pay rise over the next six-years will have to be funded with cost increases it will cause less disruption than a protracted strike.
The Bazooka from Beijing
China unleashed an economic bazooka in September that could reach up to 3.4 trillion yuan ($483bn) of fiscal support. The world's second largest economy has struggled to restore growth after a strict covid lockdown and collapse in the property market, where more than 40% of residential developers have defaulted on their debt - many of which are private. Plummeting home prices precipitated a collapse in consumer confidence with property making up the largest proportion of household wealth.
To combat this, the People's Bank of China (PBOC) is loosening restrictions on property purchases. Deposit requirements on second homes are being cut, mortgage rates will be cut, consumers may be allowed to renegotiate mortgages with competitor banks for the first time since the GFC. The PBOC will now finance 100% of the principal required for state-owned firms to acquire unsold property inventory - up from 60%. In addition, the PBOC will provide $113bn to support the stock market, which could rise to $340bn. The measures have been enacted to place a floor under asset prices and stimulate a wealth effect and increase consumer confidence and spending. The final element of the project is to inject $142bn in the form of CET1 capital into six of the largest commercial banks, boosting lending capacity.
The success of the project remains to be seen, but local financial markets had their largest 5-day gain since 2008 on the publication of this economic rocket, surging 25%. Momentum has had a clear impact in the short term, but we remain hesitant of the long-term success. In recent weeks and months many have suggested that China could face a balance sheet recession similar to Japan in the 1990s, where economic growth falls as individuals and companies focus on debt reduction instead of investing in growth. We are wary that funding these measures with special sovereign debt may prove to be a can kicking exercise rather than the bazooka Beijing hopes for.
Divergent AT1 Regulation
Australia is planning to scrap Additional Tier 1 (AT1) capital for its banks. Currently, banks down under must maintain AT1 capital equivalent to 1.5% of their risk weighted assets (RWAs). Under the new plans this will be replaced with equity capital (0.25% of RWAs) and Tier 2 capital (1.25%). The u-turn in regulation is due to a comparatively large proportion of AT1 ownership by domestic retail investors that regulators believe would add complexity and contagion risk in the event of a crisis. Assuming the changes are implemented we expect AT1 to tighten relative to Tier 2 and for Tier 2 to widen from its current levels. Return on equity is also likely to fall given a higher equity requirement.
Conversely the US is debating by how much to increase AT1 requirements as a percentage of RWAs for its largest, global-systemically important banks. Original plans for the so called Basel Endgame were for a 19% jump in AT1 requirements that, following successful lobbying, was lowered to 9%. Nonetheless, the increase in requirements will necessitate issuance, increasing the size of the market, and potentially sending spreads a little wider.
It is our view that despite technical factors from issuance, this sector of the market will continue to outperform due to the quality of systemically important bank's balance sheets and the additional coupon paid to investors. Additionally, the importance of the asset class to regulators in Europe, the UK and US, in the event of a crisis serves to protect the asset class. Europe and the UK have deferred decisions to alter their implementations of Basel rules, but we do not anticipate either jurisdiction following Australia's path and expect the sector to continue growing.
AT1 issuance has picked up from the depths of the post-Credit Suisse write down, demonstrating investor confidence, with September the largest ever month of issuance: 18 deals totalling $13.8bn (equivalent). Year-to-date issuance in sterling and Euros has already overtaken all previous years bar 2020 and 2019, respectively, dollar issuance is close to marking its second biggest year. It is also worth noting, the write-down of Credit Suisse AT1 while equity capital survived is not a precedent that other jurisdictions will follow; both the European Central Bank and Bank of England issued statements opposing the order in which losses were imposed on investors.
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