This is a bit of a broken record at this juncture, but it’s worth reiterating because at some point, it’s going to matter and when that day comes, it’ll be nice to have plenty of material to link back to.
As QE reverses, more of the onus for absorbing fixed income supply falls to the market – i.e., to price sensitive buyers as opposed to the price insensitive bid from the benefactors with the printing presses.
Naturally, this will push up borrowing costs as the marginal buyer will become increasingly fastidious, especially in light of rising yields on USD “cash”, which, you’re reminded, now yields more than global fixed income.
Don’t forget, USD “cash” outperformed nearly everything in 2018 and the allure of that suddenly viable asset class was in no small part responsible for sapping demand for risk assets of all stripes.
In Europe, spreads are now back to where they were when CSPP was first announced (see visual below). As we’ve noted on too many occasions to count, that’s the cruel irony for the ECB, which of course went ahead with plans to call an end to net asset purchases last month.
We’ve now retraced the CSPP-inspired tightening which certainly seems to lend credence to the notion that the central bank missed their window to normalize (and that contention is backed up by the economic data as well).
In any event, BofAML’s Barnaby Martin notes that all of this is likely to push debt costs higher in Europe.
“As Chart 2 shows, this year could see close to $2tr of global net fixed income supply needing to be absorbed by investors – a far cry from the 2015 to 2017 era, where investors had to grapple with an acute shortage of assets”, he writes, in a note dated Tuesday, adding that bond buyers will naturally “choose to be pickier in 2019 but for credit markets to attract the marginal buyers, we think spreads will need to be wider.”
Martin goes on to suggest that thanks to the new debt market dynamics, “companies [won’t] have the luxury of waiting to refinance bond by bond [and] moreover, Credit Rating Agencies are scrutinizing corporates’ debt maturities a lot more than in the past, and are more vocal today in urging companies to refinance ahead of time.” He goes on to say that bondholders are likely to be placated at the expense of shareholders.
Ultimately, he runs an analysis that takes a look at who the refi “losers” would be in a scenario where “European non-financials refinance their 1-5yr Euro-denominated debt into new 10yr Euro-denominated corporate bonds.”
There are a number of assumptions that go into this, but Martin summarizes the methodology pretty effectively as follows (thus saving folks who are in a hurry from having to sort through the tedious details):
We assume debt is refinanced at today’s higher debt costs, but with a further adjustment given our expectation of wider spreads and higher bund yields down the line. We calculate the change in interest expense that arises from our refinancing experiment, and show this change in terms of BofAML equity analysts’ projected EBITDA. Hence we arrive at an EPS cost for companies, due to refinancing.
The implication there – in case it’s somehow not clear – is that the EPS impact of this hypothetical refi wave would cost the companies in the table between 1% to 4% which Martin admits is “not too dramatic.”
He also states the obvious which is that somehow, that just doesn’t “feel” commensurate with how much shares likely benefited as the ECB drove risk-free yields into the floor and forced credit spreads inexorably tighter. That intuition leads directly to the following cautionary note from Martin:
Even if the EPS hits in column 8, above, appear moderate for now, we think equity investors should keep a close eye on these group of names in the table. We think their equities are likely to be more sensitive to the bouts of credit market weakness in Europe that we expect to see this year.
Right. And the broader point (i.e., the takeaway for anyone who doesn’t care about any of those names) is that this is yet another example of the domino effect that will invariably play out once the post-crisis, QE-inspired dynamic that drove investors down the quality ladder and out the risk curve starts to reverse.