Mackenzie Fixed Income Team
It was a remarkably volatile first half of 2016 and the second quarter certainly ended with another jolt: Brexit. The negative tone to risk-assets over the first six weeks of the year gave way to a significant bull market in corporate credit through the end of Q2. Contributing to this was central bank actions to provide stimulus, and reduced expectations of near-term rate hikes from the US Fed. The further extension of relatively easy monetary policies in response to subdued growth and inflation rates was a catalyst for yield curves to move lower and flatten, in many cases. The US 10-year Treasury yield moved from 2.27% at year-end to 1.47% at the end of June.
Just days before the end of Q2, the surprise Brexit vote caused an immediate, albeit short-lived, negative reaction in equity and corporate credit markets. Calming words and in some cases actions by central banks got markets rallying through into early July. All notions of Fed Funds rate hikes that were fully expected only weeks earlier have been de-priced from the market, and there is an increased expectation of more accommodation from the Bank of England, Bank of Japan, and ECB.
For credit markets, the rally since February has been very strong. High yield bonds have returned over 9% year-to-date, and floating rate loans about 4.5%. Investment grade corporate credit spreads have narrowed, creating outperformance of the sector versus government bonds. Emerging market sovereign credit spreads have moved lower, as the pressure from low commodity prices and a stronger US Dollar abated. Yield-starved bond investors piled back into these credit sectors - $3.6 billion of net inflows into high yield bonds so far this year – including the most unloved credit sectors of 2015: energy and commodities.
This short-term rally must face up to a number of medium term uncertainties. First, the Brexit process is political, and will inevitably take a great deal of time. The lasting economic impacts on the UK and on the EU are subject to the renegotiation of the many pacts and treaties that link the two today. This will not create a climate that is conducive to business fixed investment and hiring. Second, already shaken confidence in European banking since the 2008 financial crisis will likely not recover as quickly under a fog of nervousness about European growth, and perhaps an enlivened spirit of nationalism that is growing across the EU. Populist political movements have continued to gather support in recent years, and with elections looming in many EU countries in 2017, threats of politically-charged instability may not be confined to Great Britain’s exit.
The US presidential election itself presents a rare proposition to American voters: the choice between Trump, a populist candidate or Hilary Clinton, who represents the Washington political elite. It would appear that at this stage of the process, the markets have not yet begun to discount the outcome, which is far from certain. Besides, the political theatre in Europe, and its ramifications, have held centre stage.
Looking ahead through the rest of 2016, we should question whether the bond market is right to remove all implied chances of any rate increases by the Fed. While there are many things to worry about, the markets are seemingly unfazed for now. That means the FOMC may need to focus less on monitoring international developments, and revert to its previous implied bias to tighten policy, at least one time. If this comes to pass, it seems unlikely that we will see anything more than a single 0.25% hike this year. A small adjustment upward in the US yield curve may follow, but we expect US yields to remain in the low range we have experienced for a few years.
The policy environment for other major central banks is entirely different. More stimulus in Europe, the UK, and Japan is expected, as inflation and growth are lackluster. With already negative government bond yields across the yield curves of many countries, further stimulus may take new forms. International flows may be directed towards US Dollars, and therefore keep a lid on US Treasury yields.
Investment grade corporate bonds still offer good yields, particularly in North America, and credit spreads offer good value versus government bonds. High yield bond returns are likely to be driven by energy, and metals and mining, which are over 20% of the market. Defaults for these commodity price driven sectors are up, pushing up on the overall default rates in levered finance. So far in 2016 we have had more high yield bond defaults than in all of 2015, with 83% of those coming from these sectors. We expect that, for the market overall, the high yield bond default rate will hit 5% later this year.
For loans, 70% of the defaults this year are from these same two sectors, bring the default rate to 2%. Loan market total returns are less likely to be driven by commodities as the weight of issuers from these sectors is lighter, compared to the high yield bond market. Average loan prices are in the mid-nineties (par is $100), which still offers some upside potential, and the average yield of the loan market is 6%. We have a small preference for loans over high yield bonds, although careful credit selection is paramount for both markets at this point in the credit cycle.
We expect to see some volatility around corporate credit and currencies during the second half of the year. In many areas of corporate credit markets, as outlined above, prices no longer reflect the potential macroeconomic, political, and cyclical risks that can re-price these assets quickly. We have been selectively reducing our high yield, emerging market, and to a lesser extent, loan exposure. Selling is focused on credits that are fully priced-to-perfection, and no longer offer us more upside. We currently prefer investment grade corporate and quasi-sovereign credits.