Timing is everything Timing is everything Timing is everything

Timing is everything

Bonds 7 minutes to read
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  The recent volatility seen in equity and emerging market bonds has sent some investors to the sidelines, but fear leads to leaving money on the table.

We are entering that time of year when investors don’t know what to do. Some have already taken out the Christmas tree and begun preparing for New Year’s, while others are waiting until the last possible moment to decide where to put their money before 2019.
I assume that a lot of our readers fall in the second category for one very simple reason: a turbulent year in equities and emerging bonds has left many sitting on cash. 

Given that the market has just started to oscillate, some might feel that it would be wise to put their money to work before the holidays. Others, meanwhile, are inclined to save their liquidity for a future period when the economic landscape is clearer.

This is an incredibly difficult time to answer the question of allocation. Not only is volatility picking up, but central banks’ longstanding support for financial markets is waning, causing more violent market moves than has been the post-crisis norm.

Central bank disinvestment has just started, and we are still far from pre-crisis levels. We can safely assume that volatility will continue to affect selected pockets of the financial markets without a major risk of contagion until the late economic cycle turns into recession.
US balance sheet and flows of the MFI sector
Timing is everything. Remember the peripheral debt crisis of 2011/2012? Soon after prices started to recover, investors continued to perceive obvious hurdles to the Greek, Italian, Spanish and Portuguese recoveries, and some called for a bigger sell-off to come. Investors who decided not to put their money to work back at that point, however, left a lot on the table as the periphery, including Italy, rallied over the next five years.

Staying too liquid can be a big mistake. It is thus important to assess the current economic situation and locate pockets of opportunity while still keeping a conservative overall profile in light of the recent fundamental changes to the global economy’s foundation.

Bonds can play a very important part in such a portfolio, as they can provide a cushion to the more volatile equity markets. As spreads continue to come under more and more pressure, however, the key is to cherry-pick in order to avoid unpleasant surprises.

Could US high grade corporate bonds provoke a sell-off?

The US investment grade debt space is having its worst year since 2008.
US corporates
If we look inside the US high grade corporate box, we see that that lower-rated corporates with triple-B ratings have dragged the wider investment grade space lower. As you can see from the image below, while triple-A spreads have been tightening versus Treasuries by 7% year-to-date, triple-B corporate bonds spreads have widened by 20% since the beginning of the year.
Triple-B corporate bond spread, % move YTD (orange) v. Triple-B corporate bond spread % move YTD (blue)
Triple-B corporate bond spread, % move YTD (orange) v. Triple-B corporate bond spread % move YTD (blue)
This widening is worrying because it points to a deterioration of credits. The cause is increased mergers-and-acquisitions activity undertaken by triple-B companies in the past few years. This has been made possible by easy money allowing corporates to take on more debt and causing a sudden increase of leverage.

One notable example is General Electric, whose bond prices have recently fallen to distressed levels. Although Ge has only recently been affected by negative investor sentiment, the company’s situation has been problematic since 2014 when GE acquired Alstom for $17 bn in the hope of becoming a power-generation leader via Natural Gas. This acquisition was financed by debt that dramatically boosted the leverage of the overall GE structure. On top of that, GE was left with a huge debt and an underperforming business once energy prices began their protracted decline in late 2014.

The M&A bonanza is obviously only part of the story concerning the sudden widening of triple-B US corporate bond spreads. The other part of a story concerns Federal Reserve policies and interest rate hikes pushing investors to reconsider risk.

Although the triple-B US corporate space is undergoing a repricing, I believe that it is very unlikely that the widening of spreads and isolated cases such as GE can provoke a wider sell-off of the investment grade corporate space for the simple reason that investors remain hungry for yield, and widening spreads in the IG world represent the prefect opportunity to swap lower-rated corporates for better rated ones in an effort to ride out the late economic cycle and possible recession.

Short-term US high grade corporates may be the answer

We believe that this is the right moment to look for opportunities in the US investment grade corporate space, preferring short-term maturities over long. But why would we buy bonds with short maturities if we expect interest rates to push up the shorter part of the curve?

We do see short-term interest rates rising for the remainder of this year and the next, but we also believe that investing in short maturities can be a way for investors to earn interest while remaining somewhat neutral on US yield curve movements. This way, once the bonds mature, the investor will retain the flexibility to invest in new opportunities that may arise from a completely different market from the one we are looking at today. 

In this case, the triple B corporate space, which presently provides an interest pick up over Treasuries of about 150 basis points, seems to be the perfect cushion against rising inflation and interest rates, even if it may be affected by ratings downgrades.

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