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A testing May has turned into a torrid June for the US corporate bond market, vaporising returns and sending borrowing costs higher. Some analysts and money managers now believe the end of the market’s golden era is getting closer.
After initially holding up reasonably well to the turmoil in government debt markets, US corporate bonds have taken a tumble in recent weeks. The average yield of debt issued by investment-grade companies has jumped from 2.8 per cent in mid-April to about 3.3 per cent, erasing investor gains made earlier this year.
Junk bonds — somewhat insulated by the fierce moves in benchmark government debt by their higher returns — have on the whole performed better, but the yield of Bank of America Merrill Lynch’s main index for the market has climbed from 6 per cent at the start of June to almost 6.3 per cent last week.
Some shivers from the turmoil, primarily emanating from Europe’s bond markets, are natural. But the setback comes as some investors are increasingly questioning whether the phenomenal post-financial crisis run for US corporate debt is about to end.
The latest evidence of the “credit cycle” losing some of its bloom is the surge in US mergers and acquisitions activity. The value of deals announced last month jumped to $243bn, according to Dealogic, smashing past the previous records from May 2007 and January 2000.
Jack Flaherty, a bond fund manager at GAM, points out that rising M&A activity is a classic harbinger of poorer times. “That’s when corporate spreads typically start to tick up,” he says.
The reawakened appetite for dealmaking comes as companies are tapping bond markets for money at a record pace. The recent turbulence may delay some issuance, but June is expected to be the fifth month running of US corporate bond sales exceeding $100bn, extending a record-breaking run.
As a result, JPMorgan recently lifted its forecast for US investment grade bond supply to $1.15tn for the year as a whole, up from $1.05tn previously, and noted that the heavy issuance is leading to indigestion.
Companies are releveraging. Something has definitely turned, this is probably the late stage of the credit cycle.– Ashwin Bulchandani, MatlinPatterson
“Companies are releveraging,” says Ashwin Bulchandani, chief risk officer and a strategist at MatlinPatterson, an asset manager. He argues that the time has come to bet against corporate bonds. “Something has definitely turned, this is probably the late stage of the credit cycle.”
Adding to the concerns of bond bears, the market’s liquidity — the ability of traders to buy and sell securities smoothly and without moving prices excessively — has diminished dramatically. That exacerbates sell-offs and could in the worst case turn a natural correction into a crash — especially if retail investors are frightened by the fact that their supposedly safe bond funds can lose money and dump the asset class.
“The lack of liquidity, combined with the kind of money going into the market, makes us concerned,” says Mr Bulchandani.
Some investors appear to be wary of the dangers. Although retail money is still flowing into the US corporate bond market, the pace is slower than in the years following the financial crisis. Citi analysts note that investment-grade focused mutual funds and exchange traded funds have still not recouped the money that was yanked out in the 2013 “taper tantrum”.
EM most at risk from bond market ‘tantrums’
The recent volatility in fixed income markets has once again highlighted a “global warming” in financial markets: the price response to new events and data has become much more extreme due to changes in market structure.
However, there remain reasons to be optimistic that corporate borrowing costs will stay relatively subdued.
Focusing on the overall M&A volume ignores the fact that most deals are by companies rather than private equity firms, relatively conservatively structured and financed by less debt and cash than in past M&A booms, according to a study by Invesco.
“We do not see the danger signs we typically see in the later stages of the cycle — such as a preponderance of overly leveraged, financially sponsored deals that damage firms’ credit fundamentals,” the asset manager wrote in a report last week.
Moreover, despite occasional fluctuations, investor appetite for corporate debt is still ravenous. Citi’s analysts point out the fact that mutual bond funds have not started seeing outflows — given the choppiness of markets and the looming Fed interest rate increases — is encouraging. “It suggests that the bulk of the money remaining in these funds may be stickier than imagined,” the bank’s US credit team wrote in a note.
Demand from pension funds and insurers is underpinned by the need to match long-term liabilities with long-term fixed income assets. Any rise in yields will be welcomed and quickly quelled by these vast pools of money.
For that reason, Mr Flaherty has been snapping up some of the new investment grade corporate bond that have been issued in recent weeks.
Still, the GAM fund manager suspects that 2016 will be a tough year for the US credit markets, due to a combination of Fed rate increases, rising corporate leverage and the liquidity crunch.
“We should be fine for another six months or so, but then all the stars will be aligned for tough times for credit,” he says. “Then it’s time to go short almost everything.”