Just like virtually every other asset class, high-grade corporate bonds have had a good year.
In fact, at 14%, 2019 is set to be the best year in a decade for returns.
Almost by definition, a repeat of that performance (visualized in the top pane below) in 2020 is unlikely, even as analysts remain generally upbeat. BofA’s Hans Mikkelsen (who is regularly cited by the financial media) expects 4-6% total and 100bps-200bps excess returns, for example.
One thing working in favor of the market is the likely persistence of demand from foreign investors. Even with three Fed cuts on the books, USD credit is attractive in a world where yield is increasingly scarce.
Indeed, the global stock of negative-yielding debt ballooned out to $17 trillion in August, when bonds surged amid an acute growth scare tied to renewed trade concerns.
In Europe, between negative rates and the ECB bid (i.e., CSPP), the market is a veritable funhouse mirror. At one point over the summer, €1.1 trillion of European corporate bonds were yielding less than zero, around half of the entire € IG market. Around the same time, there were 100 companies in the € debt market whose entire curve was negative. In a sense, debt had become an asset for those corporates. And don’t forget about the appearance of negative-yielding “high” yield debt, the ultimate oxymoron.
Some of this abated in the fourth quarter as global yields moved higher off the August lows amid reflation optimism, Brexit progress and the interim US-China trade deal. But if you’re a foreign investor, it’s hard to escape the conclusion that, as the above-mentioned Mikkelsen told Bloomberg for an article out Thursday, “there’s only one game in town, and that’s the US corporate bond market”.
In a recent note elaborating on the year-ahead outlook for US credit, Mikkelsen summed things up as follows:
Big picture-wise we break 2020 down to the following three trade-offs (Figure 5). First the US economy is expected to slow further in 2020 to 1.7% from 2.3% this year, which is mitigated by a bounce back of earnings growth into positive territory. Second overseas yields have collapsed, which is forcing foreign investors to have more currency unhedged exposure to US fixed income. However, eventually this may become a more difficult trade as we expect a weaker dollar starting in 2Q20. Third at 100bps by yearend 2019 valuations are tough even as we expect another 10bps of spread tightening in 2020. However, that should be offset by higher equities on a slight decline in interest rates and higher corporate earnings.
Ultimately, the calculus leaves one struggling to come away with a definitive read, but if you ask Mikkelsen, supply dynamics (i.e., lower supply) is the tiebreaker and 2020 tilts bullish for spreads “by a hair’s breadth”.
And yet, what about hedging costs? While a dearth of yield may in fact be forcing some to take unhedged exposure, Goldman notes that “the universe of EUR-denominated IG bonds that yield more than their issuer and maturity-matched USD peers, on a currency-adjusted basis, remains at a near record-high level, around €700 billion”.
(Goldman)
Bloomberg cites falling dollar-hedging costs and quotes a UBS FI strategist as saying that’s going to be “a positive for demand from those investors staying pretty strong”.
BofA tracks net dealer-to-affiliate volumes from Trace as a proxy for foreign buying of US high grade corporate bonds. Negative numbers suggest foreign investor buying. In the linked piece above, Bloomberg rolls up averages for April through December. Here is a more granular breakdown using volumes before 8am NY time versus between 8am and noon, with the former being biased toward Asian buying and the latter toward European buying:
(BofA)
Still, Goldman notes that while “Euro area-domiciled investors rotated aggressively into the USD market in the period from 2015 to 2017… reflect[ing] the more attractive premium offered by the USD market, on a currency-adjusted basis, this premium is no longer available, given a much flatter US yield curve and a still near all-time high front end rates differential between the USD and the EUR markets”.
And then there’s the assumption of a stable US economy and a prolongation of the expansion. That’s obviously a key piece of the puzzle.
Leverage – depending on which metric you prefer – is high, and while timing the turn of the cycle has proven to be a fool’s errand in a world where central banks can effectively stave off creative destruction indefinitely by bringing the power of the printing press to bear on risk premia, one can’t help but think that eventually, a reckoning of sorts is in order.
(Goldman)
At the end of the third quarter, US nonfinancial companies had $15.987 trillion in debt outstanding. The figure for households was $15.986 trillion.
It was the first time business debt had outstripped household debt in 28 years.
