Given that only high-yield eurobonds (HY) rated below investment grade retain significant price upside and hence downside yield potential, the demand for FX high-yield bonds is hitting record.
Investors are becoming less picky with respect to credit risk amid rising expectations for decline in dollar rates and the lack of good issuers (most new $ issues are dominated by Chinese companies). In addition a record high of eurobonds trade at negative yield pushing more demand for high risk issues. However this does not mean that demand for low/negative yield will be falling. During recession, even a negative-yielding DM government bond will probably outperform most of Credit, Equities or EM.
Should we expect a correction, and, if not, what are the most appealing trade ideas as of today?
Global exchange assets ($218 trln)
Source: JP Morgan, BIS, MSCI, Datastream, Bloomberg, ITI Capital
Strategy for high yield bond market
- EM high yield bonds have a potential to decline further by 150–200 bps over next twelve months and US high yield bonds — by 100-150 bps
- Majority of high yield bond issuers are Chinese companies with untransparent financials low liquidity and high business risks. The share of good and liquid bond issuers from the Middle East and Africa is 12%, Latin America — 14%, from EM Europe — 8%. Therefore, issuers rated BB- or below will benefit most from limited bonds supply. For example, since beginning of the year Costa Rica’s sovereign USD denominated bonds with a composite rating of BB- rose by 22%, Ecuador (B-) by 18.5% and Ukraine (B-) by 17.5%
EM (BBG HY EM) and US (BBG HY US) HY bonds performance
Source: Bloomberg, ITI Capital
Current FX-portfolio yielding above 6%
Source: Bloomberg, ITI Capital
Current rouble-portfolio yielding above 8.5%
How the global markets performed YTD?
- Since the start of the year and until recently despite strong US NFP data for June, 70% of bond markets is posting new 12-mo lows in yields as average return for HY sovereign bonds below BB- was 20% exceeding S&P 500 (+18%)
- 20% of credit markets delivering new spread tights and over 26% of bonds mostly European sovereign issues in EUR are trading with negative yields
- 40% of equity markets reaching new 12-mo highs. Russian equities are up by 28% ytd
Why this high-speed train makes no stops?
- At best, we can witness only a slowdown by means of a technical correction, as was the case in May and, in part, in the third week of July, and more so with respect to global equities and specific stories but not for HY issuers, as they are subject to fundamental factors, such as trade wars, sanctions and other effects of geopolitical conflicts that may directly impact companies financials. The demand is supported by shifts in the global fiscal system, as the policy is easing in response to the economic slowdown. The slowdown is evident in certain regions and countries, such as the eurozone and, in part, China, but not in the U.S.
- Restart of ECB QE is possible this year and in September potential 10 bps key rate cut
- FED officials signalled they are ready to lower interest rates by a quarter-percentage point later this month, while indicating the potential for additional reductions, despite the recent surge in market expectations of a half-point cut
- Fiscal stimulus to boost the economy in countries such as China and Japan
- H2 will deliver both stimulus and stable-to-stronger growth eventually, it is still tough to embrace the broadest possible reflation strategy simply because central banks are easing and the share of negative-yielding assets is rising
What can stop the rally?
- The Gulf crisis is turning into a full-blown conflict between the U.S. and its allies and Iran, 30-40% probability
- The new stage of the U.S. — China trade stand-off (new tariffs on $300 bln-plus of Chinese imports — 20-30%
- The U.S. impose new sanctions against Turkey — 20–30% (in the wake of August 2018 crisis)
- The risk of a slowdown in the U.S. in 2020 — 15–20%
- Tough sanctions against Russia — 15–20%
- Fiscal tightening by the Fed and other global central banks (a policy U-turn) — 10%
How overheated is the high yield Eurobond market?
- YTD issuance of EM bonds at $254.1 bln is higher than the $224.4 bln run rate from the same period last year, which is due to a surge in primary activity in June. Share of HY amongst new issues is 40% exceeding for the same period last year by 20% due to surge in Asia mostly China. 67% accounted for companies from Asia (90% from China, with the bulk issued by high-yield issuers with a speculative grade rating), the and 33% — other regions: Middle East and Africa (14%), LATAM (12%) and EM Europe (7%)
- High-yield issuers account for slightly over 42% of total bonds, the share has been growing recently due to strong demand amid declining yields
EM Eurobond issues YTD
Sources: BondRadar, ITI Capital
EM HY placements are the largest since 2017
Sources: BondRadar, ITI Capital
1. Eurobonds denominated in EUR reached new historical lows in yield
- Average yield to maturity (YTM) for euro-denominated debt dropped to new low of 0.5%. Euro-denominated eurobonds account for 26% of the outstanding amount ($49 trln), dollar-denominated — for 55%
- The YTM for dollar-denominated debt is close to 2007 levels, when the Fed's key rate was 4–5%. The current average dollar yield barely exceeds 1%
- Some $13 trln, or 26% of the outstanding Eurobonds, trade at negative yield before the call, mostly euro-denominated sovereign bonds
Weighted average YTM for euro and dollar bond issues, %
Source: Bloomberg, Barclays, ITI Capital
2. Lack of good and transparent issuers
- Issues of EM Europe and Latin America eurobonds have dropped by 20% y-o-y YTD, while Asian bonds grew by 25%, in the Middle East and Africa — by 18%.
- Share of high-yield bonds account for over 42% of the outstanding amount in Asia against 25% last year
- The markets have been witnessing a significant increase in high-yield bonds volumes across many regions,but mostly Asian companies. The share of investment grade securities is declining, as their yields are at record lows
3. The bonds are pricing 60% probability of a recession in 12M
- The front end of the US curve is now pricing in more than two Fed rate cuts by the end of this year and close to four rate cuts cumulatively by the end of 2020. Not only does this market pricing at the front end of the US curve raise the hurdle for the Fed to «satisfy» market expectations, but it creates more fears of either a Fed policy mistake or of trade conflicts causing larger negative shocks, spooking both government bond and risky markets
- The 122 bps fall in 5-year US Treasury yields from their early November peak in particular, points to more than 53% chance of a US recession over the next year given a typical 210 bps decline in previous US recessions
Key assets pricing in U.S. recession in 12 months, %
Source: JP Morgan, ITI Capital
S&P 500 stocks and EM bonds performance over 5 yrs, %
Source: Bloomberg, ITI Capital
Sovereign Eurobond yield Curve
Source: Bloomberg, ITI Capital
Author:
Iskander Lutsko, Chief Investment Strategist, ITI Capital
