By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
Last week’s piece about the widening of investment-grade credit versus high-yield got so many intelligent responses, I thought instead of writing on a new topic today, I would take the lazy route and simply share the insights.
Quick recap – although most risk-on indicators are sitting near recent highs, investment-grade bonds have had a terrible six months.
So in no particular order, here are some of the explanations for this widening of IG OAS credit spreads:
- some investors wonder if the collapse of General Electric is disproportionately influencing investment-grade indexes.
- another shrewd reader notes that investment-grade bonds were a natural substitute for US-Treasuries during Quantitative Easing, and now that we are entering a period of Quantitative Tightening, IG might be feeling the effect of the Fed’s balance sheet runoff.
- a bond trader who knows more about the intricacies of the bond index make-up than I ever will suggests that investment-grade indexes are suffering from an overall decline in the credit quality of the index (ie: there are less AAs and more BBBs). Therefore, bond investors are rightfully marking up OAS IG spreads.
- one macro trader who follows the cost of hedging IG credit for non-USD investors notes that IG returns are now negative for Japanese investors who want to hedge the currency.
- finally, one trader who tracks issuer flows comments that HY companies are increasingly tapping the levered-loan market instead of issuing paper, while IG companies are selling debt heavily.
Although these are all great reasons, here are my favourites:
- the high-yield market is smaller than investment-grade, so the “dumb bid” from ETFs and other passive “risk-on” strategies has an outsized effect on high-yield bonds. So it’s not so much that IG is trading poorly, it’s that HY is trading much too frothy.
- we all know the story about how large multinational companies have been the largest investors in US dollar bonds overseas. With the passing of the recent tax reform package, companies are now incented to bring that cash back home to the United States. Hence, IG is offered.
- the recent spate of M&A’s has resulted in companies taking more leverage, decreasing the credit quality of their bonds.
But the best explanation came from Jan Leroy who argues this is all quite “normal”:
Whichever reason you are partial to, at least you now have a good list of excuses to pick from as to why IG is trading so badly…
Maybe we all have been told the story
https://www.cfr.org/blog/tax-reform-q1-2018-bop-data
“As interesting, if not more so, are the first reports of the tax rates that profit-shifting firms will pay under the new tax law.
And, well, those reports don’t suggest that the firms have any real incentive to shift either their intellectual property or actual manufacturing back to the U.S.
For example, a large pharmaceutical firm that has placed its intellectual property in Bermuda and seems to produce primarily in Puerto Rico (a part of the U.S., but outside the U.S. for tax purposes) and Ireland estimates that it will now pay a tax rate of 9%. That’s a lot lower than the tax rate it would pay if it located its intellectual property and physical production in the U.S.
It is also lower than the global minimum tax rate of 10.5% on intangibles.
The tax structure is pretty direct–put your IP in a really low tax jurisdiction, and sweep all the profits there, so that they don’t stay in the fairly low tax jurisdictions where manufacturing takes place, let alone the location of most sales. “
IG has been a head scratcher this year. While everyone’s focused on ratesratesrates, treasuries outperform similar maturity IG. Since IG has both credit and rate risk, it ‘must’ be credit risk. but here is an outside of the box idea: the problem in IG has been a decline in issuance. When there is good flow of issuance, bonds price well. IF there has been a decline in issuance, one could point at tax reform as the culprit. The corporate tax cuts have enabled companies to forego the usual borrow-to-fund-buybacks route this year, instead being able to use current (better) cash flow.
This article indicates $1.7T issued in 2017; while on ly $500B in 2018, potentially a 40% decline. https://www.washingtonpost.com/business/economy/beware-the-mother-of-all-credit-bubbles/2018/06/08/940f467c-69af-11e8-9e38-24e693b38637_story.html?utm_term=.6d925bede9a8