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  • Writer's pictureTrevor Cooper FCISI

Bond Commentary 1st November 2022

  • United Kingdom’s turmoil

  • Index-linked bonds – protection?

  • Bond buybacks

  • Telecom Italia rating downgrade

  • Argentina ratings cut again

  • Bond issuance

  • BAT’s new issue

  • More Carnival issuance to keep the company afloat

  • Lockheed Martin 5-tranche offering

  • Saudi Arabian buys and sells bonds

  • UnitedHealth Group’s largest bond offering since Meta sold $10bn in August

With investment grade bonds down over 20% on average this year causing yields to rise sharply, we believe that the bond market is now oversold and looking remarkably attractive. Of course, predicting where inflation and interest rates are going next is difficult but the enhanced yields available now will provide excellent income as well as the possibility of increased capital gain. With prices of many corporate and financial bonds now standing at a considerable discount to par, there is a large capital gain available as their price tracks towards 100 at their individual maturity dates. Therefore, we believe there is now and excellent opportunity to lock in excellent returns in lower-risk corporate bonds.

Nothing goes in a straight line of course and we can expect more volatility from all markets, however we think the investment grade corporate bond sector will be one of the best places to be in the next 4 to 7 years. As always, bond selection is vitally important for any portfolio. For existing bond holders, the injury has been done but we consider we are set to see a reversal of fortunes. The ability of locking in excellent income and the eventual future capital gains, is now remarkably attractive. Defaults could play their part, but our carefully researched bond selection will reduce downside risk in this volatile world environment. Although we cannot predict the timing, and the challenges of a possible recession and inflation remain problematic, but the opportunities that the bond market currently offers is exceptional.

United Kingdom’s turmoil

Moody’s and Fitch have followed S&P in revising United Kingdom and the Bank of England’s outlook downward to negative from stable in the last fortnight. At the time of placing its negative outlook on the UK, Fitch, said ‘The large and unfunded fiscal package announced as part of the new government's growth plan could lead to a significant increase in fiscal deficits over the medium term.’ However, soon after Fitch’s outlook change the unfunded fiscal package was largely reversed quickly followed by the appointment of a new Prime Minister. Then, after Rishi Sunak’s appointment markets moved hard and fast. The yield on the 10-year gilt plunged from 4.50%, the highest in a decade, down to 3.40% and the end of the month and the level of sterling travelled from a low of 1.07 to the dollar, at the height of the political problems, rising to 1.15 by month end. During the period when UK’s fiscal rules went out of the window the yield on gilts went higher than that of Treasury bonds for pretty much the first time ever. However, when the new Chancellor Jeremy Hunt was appointed, reversing nearly all the tax cuts previously announced, yields of gilts and bonds around the world, quickly sank back to where they were before. The UK is currently rated Aa3/AA/AA- all negative.

Index-linked securities have always been assumed to be a protection in times of high inflation. However, they have dropped like a stone this year. While the idea of using an index-linked bond to protect against rampant inflation sounds perfectly sensible, it is the price first paid for this safeguard that is important. Like so many things in life it’s where you start. Unlike 2018, when we did switch into some ‘linkers’ from conventional bonds to protect our portfolios we did not think it was correct to do so this time. For some time now we thought the *‘breakeven’ rate made them too expensive. The prices of 10-year Treasury index-linked bonds (Treasury Inflation Protected securities (TIPs)) have fallen around 22% this year compared to 20% for the conventional 10-year, so no extra protection from indexation. The real yield on 10-year TIPs has climbed from minus 1% in January to around +1.6% today. That yield is now roughly in line with recent growth in U.S. productivity – a loose proxy for the TIPs’ fair value. Investors expect inflation will average 2.5% over the next decade, only a little above the Federal Reserve’s target.

*The bond breakeven rate measures the difference or gap between a risk-free security, conventional gilt or Treasury bond, and their index-linked equivalent. This breakeven rate serves as an indication of the markets’ inflation expectations over the period in question. For TIPS investors, the breakeven rate can be considered a hurdle rate—it's what inflation would need to average over the life of the TIPS for it to outperform the nominal Treasury.

Bond buybacks

As I mentioned in our last Bond Commentary, companies are taking advantage of the market selloff to buy back their own cheap debt. Aston Martin and Softbank both bought their bonds back in September, early October saw Credit Suisse joining them. The Swiss lender announced that it would buy $3bn worth of its senior debt. At this level of the market, we will see more companies coming to their bondholders to buy their bonds back.

Last week Credit Suisse announced a loss of $4bn causing its shares to drop 19% from an already historic low level. The Swiss bank seem to have been forced into this drastic action by its woefully low share price. The market value of the company is now less than a quarter of its book value, or its assets minus its liabilities. That's a clear sign that the market sees no meaningful profits in the foreseeable future. It now looks likely the bank will be split into four parts. It does seem that the bank wants to keep investors on their side and bondholders seem to have picked up on this. For example, the price of the bank’s $2bn junior subordinated AT1 bond, that has a call in July next year, has had a volte farce in the last month rising from an all time low of 75.00 to 89.00 now, in the hope of the call being exercised.

S&P lowered Telecom Italia's credit rating to B+ from BB-, with a negative outlook. The rating downgrade was prompted by a weak macroeconomic environment and the Italian telecommunication company's large debt maturities over the next 24 months amid high-interest rates. This year Telecom Italia’s shares have fallen 56% to their lowest ever level. Overall, Telecom Italia ratings, which have been on a slow decline, are B+/B1/BB, all negative.

The International Monetary Fund approved $3.8bn in funding for Argentina on 7th October, the third tranche of funding from a $44bn, 30-month package approved last March. The Argentine currency and its debt have collapsed over the last years.

Last week Argentina crashed deeper into sub-investment grade by Fitch on risk the nation’s deep macroeconomic imbalances and ‘highly constrained’ external-liquidity position will undermine its ability to repay debt. Argentina was cut by one notch to CCC-. Fitch said that the downgrade ‘reflects deep macroeconomic imbalances and a highly constrained external liquidity position’, which Fitch expects to increasingly undermine repayment capacity as foreign-currency debt service ramps up in the coming years. Argentina’s bonds are trading around the 20c in the dollar.

Bond issuance

High yield issuance continues to massively fall behind previous years. To date we have only seen around $90bn against yearly totals in the last 2 years of $458bn and $432bn respectively. This is against over $1trn of investment grade issuance so far this year, just 13% off last year’s total.

New issuance in sterling predictably slowed to almost a standstill with the turmoil of the UK’s politics and the volatility of its currency and gilts taking their toll.

BAT’s new issue

One of the most successful primary issues last month was for tobacco company B.A.T. The footsie 100 company launched a $600m 10-year senior bond with a coupon of 7.75%. Investors liked what they saw, putting up 5.8 times the issue size. The bond was issued in the name of American company BAT Capital Corp. and is rated Baa2/BBB+, both stable. In March B.A.T. launched a $900m 10-year bond on a yield of only 4.742%, this time around B.A.T. had to pay a coupon of 7.75%. Since issue the bond has unsurprisingly performed very well with the +380bps issue spread tightening to +335bps.

Despite being downgraded to B3 by Moody’s in August, Carnival was still able to sell $2bn of 2028 bonds, albeit on a high yield of 10.375% yield last month. This is the latest borrower to pay up to refinance a heavy debt load as fears of a recession mount. Due to good investor demand the cruise line operator was able to increase the deal to $2bn from $1.25bn earlier proposed and was able to reduce the coupon from the 11.5% first mooted to a final 10.375%. The bond has a series of calls at various dates starting in 2025. Incredibly, this is the ninth time Carnival has tapped the primary market since the start of the pandemic in 2020. Since launch this bond has performed very well and tightened from +649bps at launch to +625bps. Like so many struggling companies this year Carnival’s share prices has dramatically fallen this year, by 55% in this instance.

Lockheed Martin 5-tranche offering

Lockheed Martin’s new multi-bond offering was expected to be sized at $3.5bn but they were able to launch a $4bn deal, in the end. The 5-part sale with 3, 5,10, 32 and 41-year bonds. This was Lockheed’s second deal of the year and was particularly popular with investors who put up a total of over $20bn for the $3.5bn transaction. Lockheed Martin senior unsecured bonds, are rated A3/A-/A-, all stable.

Saudi Arabia sold $2.5bn of 6-year sukuk bonds and $2.5bn of 10-years bonds at the same time as tendering for $15.5bn of its bonds due in 2023, 2025 and 2026. Both new offerings were very successful attracting an orderbook book of $26.5bn for the $5bn of bonds offered. With coupons of 5.268% for the sukuk and 5.5% for the conventional bond. Saudi Arabia has always been well rated, and this year S&P and Fitch have put their ratings on positive outlook. Currently the Middle Eastern country is well rated at A1/A-/A, stable/positive/positive. Since launch both have performed very well.

The Middle Eastern country also invited holders of its $3bn 2.875% notes due 2023, $4.5bn 4% notes due April 2025, $2.5bn 2.9% notes due Oct. 2025 and $5.5bn 3.25% notes due 2026 to tender any and all of their notes for purchase by the issuer for cash.

UnitedHealth Group’s largest bond offering since Meta sold $10bn in August

UnitedHealth Group launched a $9bn jumbo trade last week. The launch proved highly successful with investors putting up $36bn for the deal. The orderbook was heavily biased towards the longer end as investors look towards buying longer durations. Bond sales of this size have been rare in recent months, as companies grapple with soaring borrowing costs and uneasy investors. The 30 and 40-year tranches, with a total issue size of $3.5bn between them, raised $9.4bn themselves. All the 7 tranches of the healthcare provider’s new deal were trading tighter, with the longest 40-year part performing the best. UnitedHealth is rated at A3/A+/A, Positive/stable/stable.

The proceeds will go toward general corporate purposes, including refinancing the commercial paper used to partially fund UnitedHealth’s acquisition of Change Healthcare Inc.

Trevor Cooper FCISI

Chief Executive Officer

Chief Investment Officer

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