20 Nov 2017
Weekly Digest: A rose by any other name…
When I was working in the United States in the 1980s, I heard a banker tell a story of how he pulled up alongside Michael Milken at traffic lights in Los Angeles at 3am. He shouted across to ask him which party he was coming home from. Milken reportedly replied: “What do you mean? I’m on my way into work!” Michael Milken was a pioneer of the Junk Bond market while working at Drexel Burnham Lambert, and, despite subsequently falling from grace, obviously had a strong work ethic. Junk Bonds were originally corporate bonds that had lost their investment grade status, as defined by credit rating agencies, owing to poor performance by the issuing company. Milken was one of the first to get companies to issue bonds that failed to attain investment grade status from day one. These were normally used to finance highly leveraged deals, and helped to spark a boom in mergers and acquisitions. This all ended in tears, driven by a combination of higher interest rates, a faltering economy and shady practices.
Junk Bonds still exist, but these days are better known as High Yield bonds. Unsurprisingly they have been in great demand during the period of low interest rates following the financial crisis as investors have scrambled for income. They were a key component of financing for the shale oil drilling industry in the US. Drilling for oil is a highly speculative activity, so this form of finance was perfect – investors were hoping to be paid more for the extra risk they were taking. At one point the energy sector alone accounted for over a fifth of all High Yield bonds. Unsurprisingly investors did not respond well to the collapsing oil price in 2015/16, when it looked as if many of the issuers would not survive, and the whole sector came under severe pressure. That was good for us as it offered a great buying opportunity.
Fast forward to the present, and the High Yield sector is making headlines again. It has been under a bit of pressure, partly owing to poor performance by some issuers, but also owing to uncertainties around US tax reforms. That nervousness has transmitted itself to equity markets. Credit markets tend to be a lead indicator for equity markets, and although there has historically been a lag of several months it is testament to the twitchiness of investors at the moment that equities followed credit markets lower almost immediately. I don’t want to dismiss the risk completely, but things need to be put into context.
|FTSE 100 Weekly Winners|
|British Land Company
|Berkeley Group Holdings||3.9%|
|London Stock Exchange Group||3.4%|
|FTSE 100 Weekly Losers|
|Babcock International Group
|Marks and Spencer Group||-5.6%|
|Coca-Cola HBC AG||-5.2%|
A lot of emphasis is placed on two particular High Yield Exchange Traded Funds, the SPDR Bloomberg Barclays High Yield Bond (ticker JNK) and the iShares iBoxx US$ High Yield ETF (ticker HYG). These have been the favoured vehicles of (mainly) retail investors who want to allocate funds to the sector, and also the easiest proxies for observing the ebbs and flows of the asset class. Their combined capitalisation is around $30 billion currently, but between them their Assets Under Management dropped by $3.6bn (more than 10%) despite the Net Asset Value of the funds falling by only a little more than 2%. Weekly US fund data reported a net sector outflow of $5.1bn during the week to last Wednesday. The overall market has fared better, even allowing for accrued interest payments. The Bloomberg Barclays Global High Yield Total Return Index, accounting for $2.5 trillion of issued bonds, fell just 1.3% from its mid-October peak to last week’s trough.
So we are far from seeing a rout here. Indeed both credit and equity markets regained their balance towards the end of the week. Certainly, we are at the stage of the economic cycle when it is unreasonable to expect to make big capital gains from holding corporate credit. Underlying sovereign bond yields are arguably bottoming out (this is another whole debate in itself), and credit spreads, or the extra amount of yield demanded by investors to compensate for the extra risk, are not expected to compress further. But you still get the yield, which is currently 5.4% on the Barclays Index. That’s known in the trade as the “carry”, and it’s all we are expecting to get (while still attractive enough to retain some exposure). There will no doubt be more wobbles in the High Yield market, and we will continue to monitor them. For now, we don’t think this is the beginning of something worse.
Today’s big news centres on the travails of Angela Merkel, and her failure to knock together a coalition government. We recognised this as a potential risk, and I included it as one of my bricks in the “wall of worry” markets might climb over the rest of the year when I was doing the rounds in September and October. As often is the case when it comes to political uncertainty, it was the euro that took the hit first thing this morning, but, as I write, it is back to where it ended last week. There appear to be three possible paths that can be taken from here: Merkel could attempt to form a minority government; she could try to resurrect a coalition with the Social Democrats; or she could allow another election to be called. The last option risks further gains for the far right Alternative für Deutschland party, even if there is no evidence that they have gained momentum since September. That is probably the biggest fear. Otherwise, though, we continue to believe that Europe’s economic recovery has sufficient momentum not to be derailed by German domestic politics.
Finally, the national airline of Indonesia takes its name from Garuda, a bird in Hindu mythology. This week, under which President was the date of the US Thanksgiving Day holiday set as the fourth Thursday in November?
Year-to-date market performance
FTSE 100 Index, past 12 months
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