Unlocking Markets: the renewed interest in investment grade

Unlocking Markets: the renewed interest in investment grade - Marc Stacey, BlueBay Senior Portfolio Manager, and Mike Reed, Head of Global Financial Institutions

Mike Reed
Hello and welcome to Unlocking Markets, the RBC BlueBay podcast where we bring you experts from across the firm providing opinions on markets, global policy, sustainability, and macroeconomics and how these feed into our investment decisions. I'm Mike Reed, head of Global Financial Institutions. Today I will talk to Marc Stacey. Marc is a senior portfolio manager focusing on non-sovereign debt and specialising in financial institutions. We will be focusing on the market for investment-grade investors, which has been very much at the forefront of many of our clients' minds as we start 2024.

I'll be asking him what's in store for credit spreads, his views on the outlook for corporate issuance, and getting the lowdown on the financial sector. As ever, I shall be getting his opinions on where the potential dangers may lie. Welcome, Marc. We have a lot to get through today, so let's dive in.

Marc Stacey
Thanks, Mike. Thank you for having me.

Mike Reed
Good to have you here. Let's start off. 2022 was a pretty disastrous year for bond markets. This was then followed by 2023, which produced a roller coaster ride before finishing in positive territory. As we enter 2024, what should investors expect now?

Marc Stacey
Yes, look, I think 2023 was a roller coaster. I think coming out of 2022, a lot of investors were glad to see the end of 2022 and were looking to 2023 as a bit of mean reversion and hopefully an asset class or certainly risk assets that were going to rally because you'd had the worst performance of your 60/40 portfolio as we'd ever seen. I think 2023 started off relatively well, but then obviously became increasingly bumpy as the year went on.

While it finished in positive territory, I think European corporate bonds delivered 8%, US corporate bonds delivered 8.4%. Look at the US corporate bond returns, 9.6% of that came in November and December. They were actually negative before the last two months of the year. From that perspective, I think it was a roller coaster year. There was certainly some volatility, particularly in financials. The US regionals came under increasing pressure. You had Silicon Valley Bank, you had Signature that were potentially a huge catalyst for a risk sell-off.

You actually saw rate cuts being priced into markets as a result. I think the light regulation that US regionals had enjoyed obviously came to the fore when you saw government bond yields move materially higher and the marked-to-market losses that was leading to the US regional banks, obviously saw them come to a huge amount of pressure. Also in Europe, let's face it, we had one of the biggest bank defaults with Credit Suisse being merged with UBS in the end. That ended up with 6.5% of the A Tier 1 market, the CoCo market, defaulting.

It was a roller coaster year. Looking forward to 2024, where does that leave us? Yields are fairly attractive. When you look at investment grade yields, we're not quite at the highs, but certainly over the last decade, you're getting pretty attractive yields and yields that we haven't seen for, as we said, over 10 years.

I think from the perspective that the macro is still fairly uncertain, but the messages that we're getting from central bankers are that terminal rates have probably been reached. As we look forward, yes, rates might be stickier for longer, maybe we're pricing in too many cuts as we look for the first half of the year and the second half of the year. Certainly, the idea that rates have peaked and if anything, are moving slightly lower means that fixed income and certainly investment grade within that starts to look quite attractive, and we're seeing those flows.

Mike Reed
That really sets the scene nicely. Talking about rates, last time on we had Kaspar Hense, and he'd spent a lot of time talking about core government rates. Although core rates are a significant driver of overall returns for investment-grade bonds as well, the premium from credit spreads can also add to overall returns. How do credit spreads look now both in Europe and the US? In addition, should investors be concerned that if we go into an economic downturn, which some are predicting, that this will drag spreads wider and defaults will build up lower down the credit spectrum and drag investment grade spreads wider?

Marc Stacey
Yes. Look, we've said how our yields are close to decade highs. From a spread perspective, you also have a decent spread pick up, particularly in euros. When we look at yields, you've got European yields just inside 4%, you've got dollar yields just higher than 5%. The cross-currency basis of 1.5% roughly brings those two asset classes in line from a yield perspective. When it comes to a spread perspective, it's actually at 140 basis points over in the European corporate bond space. It looks relatively attractive. If we look over the last five years, you've only been wider than 140 basis points 30% of the time.

I think many fixed-income asset classes, US credit, high yield are on the tighter end of that sort of spectrum over the last five years. When it comes to European corporates, they're actually at fairly attractive levels. Now there's certain reasons for that. We've obviously had the Ukraine invasion by Russia, and that sent energy prices materially higher. We have moderated the energy price, but we're still double where we were pre-invasion. Structurally, there've been some big question marks around some of the countries within Europe that will struggle with higher energy prices, Germany being one of them.

Certainly this idea that you have a 35 basis points pickup now and spread versus dollars we think is relatively attractive in a euro versus US dimension. I think when you think about the credit metrics and the fundamentals of investment grade, we're still in very good shape. We're at levels that are probably going to deteriorate, in particular, if growth starts to slow. When we look at interest coverage, when we look at the dynamic of having to refinance debt, a lot of that was done over the course of 2020 when yields were incredibly low. From a corporate perspective, fundamentally, we're in decent shape and certainly good shape to be able to weather any cyclical or growth downturn that we might experience in the future.

Mike Reed
Should we put it in perspective there that 35 basis points might not sound like a huge amount but that is 10% additional extra returns, that's quite a lot extra there. Obviously, that's one side of the technicals. On the other side, there's obviously issuance. Within the government space, when Kaspar was here, he was talking a lot about the large deficits that need to be funded and there's going to be a lot of issuance in that sector and there may be some difficulty with investors absorbing all of that. Turning over to corporates though, is there a similar dynamic or is it slightly differentiated?

Marc Stacey
Look, we've already experienced record issuance on the sovereign side in the few weeks that we've had of January. That's been met with record demand. This idea that we painted at the beginning of this chat where central bankers are trying to message that we've reached peak rates and if anything, rates are likely to fall, albeit we can argue about the pace of that, I think that has brought in a lot of investors into fixed income, whether it be sovereigns or corporates.

When we think about the record issuance in sovereigns, yes that's true but we've also had record demand. Spain received 130 billion of bids for their 10-year bond sale. Belgium got 72 billion for their 10-year bond sale. UK 20-year bond auctions saw record investor demand. I think this idea that yes, there is going to be increased supply, there's a huge amount of supply obviously in sovereigns to meet some of the fiscal needs. When it comes to corporates, we don't seem to have quite the negative technical, high yield is enjoying negative net supply. That should start to pick up now as you have a wall of refinancing in 2025 and that tends to get refinanced six to 12 months early and so in 2024 that should pick up.

Corporate supply has obviously been meaningfully lower post-2020 when as I said you saw that huge pickup of around about 400 billion in supply. I think you're more likely to get anywhere between 230 billion to 290 billion, which is akin to what we experienced in 2021, 2022, and 2023 was a 290 billion year. Net supply I think in corporates is going to be quite moderate. There's no M&A activity to speak of that we're going to be using to finance, and it's going to be quite opportunistic I think from a corporate perspective. When it comes to financials, there's always a fair degree of gross supply, but again I think that is going to be materially lower than what we experienced in 2023.

Net supply in certain parts of the capital structure is actually going to be flat like A tier 1, for example, but because we have the long-term refinancing operation (LTRO) rolling off, which was the extraordinary government scheme to provide funding for banks. That is now rolling off and obviously what we're seeing is covered bond supply is going to replace that where you have the security of those assets being backed and that covered bond supply should increase. That means that senior preferred and senior non-preferred should pick up slightly. Again, net supply down on what we experienced in 2023.

Mike Reed
That's a nice link into my next question I've got for you because we've mentioned financials a couple of times. We can't really talk too far about investment grade without talking about financials. You mentioned what happened last year. They make up about 30% of the benchmark, so the sector can and has, as you said, in 2023 had an outsized impact on overall returns, both negative and positive. Following that volatility, the Credit Suisse issues, the issues in the American regional banks, what do you see the fundamentals for the sector looking forward in 2024? Are they more balanced now or we should be still concerned?

Marc Stacey
No, look, I think the fundamentals are incredibly robust. I think away from the US regional banking system, which perhaps still has some question marks around the equity case for those particular institutions, in particular in light of the increased regulation that we should see. When we look at what happened in Europe, the European banking sector has been regulated to the degree that it is far, far safer today than perhaps it's been in the last 20 years.

As a result of the financial crisis, you've had the business models meaningfully change, one from going to where banks had large proprietary trading desks to one where now there's much more reliance on net interest margin, on advisory, on brokerage, on asset management. Banks are more utility-like from a business perspective than they've ever been. At the same time, we've increased the amount of capital and liquidity that banks have to a huge degree. If you think back pre-crisis of 2008, banks had roughly around about 6% in equity on balance sheets. Today, that's close to 16%. We've added over a trillion euros worth of equity onto banks' balance sheets.

Not only are the business models much safer, but the amount of equity that we have that sits on the capital structure is meaningfully higher as well. To give you a sense of what that looks like, during the financial crisis, we only lost on average, I say only, but it was 6% of capital was eroded as a result of the financial crisis. If you think we've added 10% of equity on top of that 6% to take us to 16, even if we had a repeat of the financial crisis, and as I said, the probability of that is much, much lower today because of the change in business model. If we had a repeat and we lost 6%, you're really going from 16% to 10%.

While that might be pretty diabolical from a market-to-market perspective for equities, actually as bond investors that are senior in the capital structure, there's still a huge buffer that we enjoy from that extra capital that's been added to banks' balance sheets that sits beneath us. Additionally, I think fundamentals are looking pretty good for European banks. If you think about the macro scenario where we've gone from negative 50 basis points to 400 basis points at the central bank, you've gone from an environment that was very difficult to make money because interest rates were negative to one where you've got this tailwind from a profitability standpoint.

We've seen this in the numbers. We saw back in 2020, banks only made about 200 billion. 2023, that number increased to 340 billion. Even if we have some of the rate cuts priced into 2024 filter through, that number is still likely to be in excess of 300 billion over the course of 2024. You've got this huge dynamic of a profitability tailwind at the European banks. At the same time, from a valuations perspective, we've talked about Europe versus US and Europe looking relatively attractive versus US. Even within Europe, you see banks trading meaningfully back of where corporates are trading.

A lot of this is because of what happened with Credit Suisse and what's happened with the US regionals, I think, from a fundamental perspective, we just don't see why you should have this huge pickup now in financials versus non-financials, and particularly in light of the macro dynamic that we're experiencing.

Mike Reed
Now, that is very reassuring and very interesting to hear such an in-depth analysis of it there. Okay, well, I have to come to this one. All portfolio managers like to highlight the opportunities in their asset classes. There are risks. We have to acknowledge that. Not least, I'd say, is the rising political tensions in geopolitical tension in the Middle East. Including this, what would be your main concerns at the moment as you look at your portfolios, you talk to investors, what are the main concerns on your radar right now

Marc Stacey
Look, I think you're right to highlight geopolitics. I think that's always the left tail risk that's very difficult to predict. You've got Ukraine and Russia. You now have the Middle East conflict that has all the potential to be escalated. I think already you're seeing attack on the Houthis in the Red Sea and bringing in some of the surrounding regions as well. Could that be a catalyst for a wider conflict in the Middle East? Perhaps. What effect does that have on inflation as well? Already shipping rates start to pick up, and this directly impacts Europe.

If you see shipping rates doubling or tripling again, this is going to feed into inflation. I think the ability for the ECB to then cut rates if inflation is sticky or even moving higher becomes increasingly problematic. I think geopolitics is certainly a risk and one we're watching. Over 50% of the world's population is voting in 2024. That always has the potential to be a catalyst for a fair bit of volatility. I think growth, look, monetary policy always acts as the lag. We've had a huge rate increase from zero or even negative rates in Europe to 400 basis points.

Does that eventually filter through into growth and to growth prospects? I think ultimately it will have a bit of a drag and that's a concern for credit spreads. I don't think that is our base case by any means, because I think actually the unemployment rate being so low and households and corporate balance sheets being in decent shape means that default rates pick up, but only marginally, growth dynamics are still going to be relatively robust. If we have recession, maybe it's slightly negative. None of that is of particular concern, but certainly is something that we need to be alert to and alive to the risks.

Mike Reed
Yes. Okay. There's a lot going on out there, but I guess at least with where rates are and where yields are, you've actually got some carry to help protect you at this point in time. I guess, we talked about the volatility of the markets last year and how it was a real rollercoaster ride. The bond market, as you said, didn't really get going until November. 100% of the year's returns were generated in the last two months of the year. This definitely caught a lot of investors off guard, and it's generally quite a period for investment decisions. As we enter 2024, are you seeing traditional long-only investors starting to re-engage with the market, or is there a degree of skepticism out there still?

Marc Stacey
No, look, I think what we've seen is as rate volatility has subsided, you've seen an increasing interest in fixed income and a move into it's not only government bonds, but also into corporate bonds as well. I think you've got this dynamic where there's been a huge amount of money poured into money market funds. I think that number is close to six trillion in the US. I joke with colleagues that is a warm sort of blanket when you're getting 6% in cash. If we are going to see the rate cuts start to filter through, and that 5% that you're getting in the US trends towards the 3.8% that we're pricing for 2024, I think increasingly that six trillion starts to try to find a home in fixed income.

I think that trend has started, and I think that will continue over the course of 2024. A lot of the upside that we saw in November, December is obviously being missed. I think there's a huge amount of upside still to be gained. I think some of those attractive areas that we mentioned, European corporates, financials within that as well, are going to be particularly attractive and should deliver good risk-adjusted returns over the course of 2024.

Mike Reed
Thank you, Marc. That was a really interesting insight into an asset class that forms a core building block in many of our clients' portfolios. We will be back next month with another episode of Unlocking Markets. Until then, you can visit the RBC BlueBay Insights pages for our latest thoughts across markets and asset classes. Good luck and goodbye, and thank you very much for listening.

Marc Stacey
Thanks very much, Mike.