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All good things have to come to an end – and so it is with the five years of easy money offered by central banks. In May last year, the US Federal Reserve gave a clear signal that it would start to withdraw its extraordinary monetary stimulus.
Markets drew a simple conclusion – interest rates would rise and bond prices would fall. Between May and December that was the case as the yield on the benchmark 10-year US Treasury spiked from 2% to 3%. But since the Fed actually started to embark on its steady programme of withdrawing an extra US$10bn of quantitative easing every month, yields have fallen.
And they have not just declined a little – they dropped from just above 3% on New Year’s Day to around 2.5% in mid-May. Over the same period, the 30-year yield dropped from almost 4% to 3.4%.
One reason was that fears of an acceleration in the tapering programme and an early start to rises in official interest rates had faded in the face of weak GDP growth in the first quarter and doveish language from Fed chair Janet Yellen.
Now, investors are focusing on each new piece of data and speech by a voting member on the Fed’s governing body.
“There’s a lot of scrutiny and focus on the Fed on exactly what the Fed’s response function is,” said Anton Heese, co-head of European rates strategy at Morgan Stanley. But the consensus is clear, he added: “The conviction that yields must eventually go up remains in place but the timing remains very uncertain.”
Expectations of rising interest fuelled demand by issuers to lock in lower yields before rates rose any further – a phenomenon seized on by issuers, especially in the sovereign, supranational and agency sector.
Jonathan Brown, head of European fixed-income syndicate at Barclays, said that even in December, some issuers thought the current interest rate environment would not last forever and that they would be better to fund sooner rather than later.
“That’s been the mindset for a while. A number of the SSA issuers continue to pre-fund early and take size out of the market because of low rates,” he said.
Canada sold a tightly priced five-year US$3bn benchmark issue in February that attracted US$8.8bn of orders. A month earlier, the World Bank sold US$4bn of 1.875% March 2019 bonds.
European sovereigns, especially in the periphery, took advantage of the investor demand and an upturn in their economic outlooks to raise money at record low yields, said Heese.
“We have seen a front-loading of issuance in 2014 that has been quite different from the issuance trends we had seen from 2010 to 2013,” he said. “We have definitely seen many issuers take advantage of market conditions to tap the market early when conditions were good.”
Issuance in 2014 by SSAs in euros had reached €626bn by May 22, an increase of 10.6% on the €566bn raised in the same period in 2013, according to data from Societe Generale.
“It’s a really interesting dilemma for both issuers and investors, because there is a question mark on whether rates in the US will go higher at some point and probably markedly higher over time. People have to be invested and they have to have flows into the bond market”
Corporates do not tend to look so much at pre-funding as, unlike SSAs, they do not have targets but instead respond to specific funding needs rather than accumulate cash that would just sit on the balance sheet.
A good example was VW’s €3bn hybrid bond issue to finance its offer to acquire the remaining shares in Scania, the Swedish truck-maker. However, even here the data from SG CIB pointed to a strong trend, with corporate issuance in US dollars up 7.6% to US$410bn from US$381bn and in euros by 19.1% to €137bn from €115bn as corporates followed a path of disintermediation – ignoring bank loans in favour of bonds. European banks’ bond-raising, meanwhile, has jumped by 52% to €175bn.
“There are structural forces on the supply side that will continue to push borrowers to raise financing in the bond market: disintermediation on the one hand, deficits for sovereign borrowers on the other, and the rebuilding of hybrid capital ratios by banks,” said Demetrio Salorio, global head of DCM at SG CIB.
Only way is up
More than a year after the start of the taper tantrum, most issuers and investors are resigned to a steady increase in rates and yields in US dollar and sterling-denominated markets as the Fed and the Bank of England prepare for their first rate hikes.
“It’s a really interesting dilemma for both issuers and investors, because there is a question mark on whether rates in the US will go higher at some point and probably markedly higher over time,” said Brown. “People have to be invested and they have to have flows into the bond market.”
“We have seen in the recent past some large investors make the wrong bets on Treasuries or taken the view that this is the point of inflection on rates and have got it wrong”
For SSA issuers and others that tend to re-fund, the next big milestone is late this year, in September and October, when they tend to decide their financing strategy for the coming year.
For investors, the outlook is a lot more challenging as they need to take a position on when rates will start to rise and how fast.
“We have seen in the recent past some large investors make the wrong bets on Treasuries or taken the view that this is the point of inflection on rates and have got it wrong,” Brown said.
Heese said the consensus was that yields had to go up but the whole timing of that rise remained pretty uncertain. “There is a conviction that yields must go up at some stage but the market still feels it’s some time off before the Fed will actually start to raise interest rates. Hence, it is difficult for people to get too bearish just yet.”
Brown said that for investors the issue was not the increase in rates but the pace of the climb. “It’s less important where we end up on interest rates and more important that we get there in a stable way rather than have some form of overshoot.”
Keep calm, carry on
The situation in Europe outside the UK is very different, thanks to what Morgan Stanley economists have called the great monetary policy divide. Not only did expectations of looser monetary policy push up prices of German Bunds, so forcing down their yields, but better news from the periphery reduced the spreads within the eurozone.
The 10-year Bund yield has fallen from 2% to 1.4% this year while the spread between Bunds and Italian bonds has narrowed by a whole percentage point.
Heese said Bunds looked “very rich” but that it was not obvious what the catalyst would be to trigger a correction. He added: “As long as you are in an environment where you don’t think things will get imminently worse, the pressure will be on spreads to continue tightening because it is a positive carry trade.”
He pointed out that the low yield environment was proving “very painful” for long-term European investors such as pension funds and insurers that needed to match assets to liabilities.
“For many investors higher yields would be manna from heaven,” he said.
While rises in yields may bring some relief to that sector, Salorio said he doubted the impending rises in rates and yields would do much to derail the trend for great issuance and increased demand in the remainder of the global bond market.
“Rates are not going up much and with the growth and inflation prospects that are in front of us we don’t see rates going up massively,” he said. “There are limited alternative investment options: investors’ asset allocation rules are quite rigid in terms of allocation, and so there will no significant flight to equity that will eventually deprive the fixed-income market of demand.”