By Henrietta Pacquement
Credit markets are in a dither. Investors have just been given a wakeup call by the Fed. We remain in an environment where growth and inflation are under downward pressure. The developed world has little public balance sheet flexibility. Emerging markets need to strengthen their institutions to ensure efficient allocation of capital. But fear of rising rates has got the better of greed, particularly as investors anticipate the upcoming seasonal drop in liquidity. The past few weeks have been an interesting test case of how fixed income markets are likely to react when the time comes for rates to really rise.
There are signs of ‘lower for longer trades’ unwinding. These particularly affect the belly of the interest rate curve. Their aim is to benefit from positive carry and roll down. If rates rise, they quickly start losing money hence a dash for the door. Other QE driven trades are long end steepeners. In this case, expectations are that easy money will eventually fuel inflation causing longer dated bonds to sell off.
Rates markets are also vulnerable to hedging activity. For instance, the US mortgage market is predominantly fixed and subject to negative convexity. A portion of these bonds is held by investors that structurally hedge interest rates making them interest rate sellers in a rising yield environment. There is increased appetite for interest rate hedged or short duration credit funds. The blossoming of this type of product will create further structural rate sellers.
On the credit side, iTraxx indices have widened. Cash credit has cooled off. Higher beta names are being pushed around in both cash and CDS. Cash curves have seen a degree of steepening as investors shun the longer end. Credit asset classes that benefited the most from the search for yield, namely high yield and emerging market debt have been the most vulnerable.
Much of the widening in credit spreads and CDS can be put down to poor liquidity. Following the financial crisis banks’ ability to warehouse bonds has been reduced significantly. Estimated primary dealer holdings of corporate bonds in the US have been divided by four from the 2008 peak. The number of dealer quotes per corporate bond has also shrunk significantly.
Retail outflows in the credit asset classes have started, but have yet to build up momentum. Credit Suisse estimates retail oriented funds to represent some 12% or so per cent of the Euro investment grade corporate bond market. In high yield the proportion is higher at 20%. Given reduced counterparty capacity, movement in this section of the market is likely to put pressure on spreads. This may happen even though flows don’t end up materialising as asset managers build up cash balances. It is worth noting however that institutional investors may mop up loose bonds as there is a structural need to invest in fixed income assets, be it from pension funds or insurers. Indeed, credit offers better risk return characteristics in this low rate environment than government bonds.
All these various effects will make controlling the curbing of easy monetary conditions very tricky. It was always going to be the case given the experimental nature of the policies involved. However, the Fed is unlikely to want all its hard work unwound in a disorderly fashion. It can easily sound more dovish and modify its purchase policies up or down. We are likely to enter a period of increased rate volatility as the Fed overshoots one way and the other. The recent credit market movements are a healthy breather in spread tightening and an opportunity for the market to re-price risk.
Henrietta Pacquement is a portfolio manager at ECM Asset Management
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