It’s halfway through the year and global markets continue to be hit hard by the various economic figures being produced, higher inflation forecasts and of course the continuing Russian/ Ukrainian war. Equity markets have continued to fall with the S&P 500 down 19% the worst start to a year in half a century. The tech rich Nasdaq index has fared even worse, with a 29% drop. In Europe, the DAX index has fallen 21% and the Footsie 250 index is down 20% from the start of the year but, interestingly, UK’s main index the Footsie 100 is only down 1%.
The 10-year U.S. Treasury bond reached the highest yield for over a decade in June after reaching almost 3.50% mid-month, since then it has retreated to finish the month at 2.88%. The Treasury 5–30 year curve has inverted twice this year, first in April and secondly mid-June, but it has since bounced back to a small steepening. Historically, an inverted yield curve has been viewed as an indicator of an approaching economic recession, but the New York Fed president said last week that he is not expecting one but does see a further large rate rise at the July meeting. Investors are now pricing a 175bps rise, up from 100bps, from the Federal Reserve’s September decision. The Bank of England has raised rates at each of its past 5 meetings and has started unwinding its QE program. We believe that UK bank rates will continue upwards to 2.5%. The rise in inflation in Europe and America is exceeding all forecasts. US inflation hit a 40-year high of 8.6% as food and gas prices rose. The U.S. Federal Reserve will probably raise its interest rate 75bps this month taking its rate to 2.25%-2.50% followed by another 50bps in November. By the end of the year the fed funds could range to 3.25%-3.50%. It is believed that U.S. inflation will remain above the Fed’s 2% target until at least 2025.
It’s all been a bit much for corporate borrowers this month. As inflationary pressures continued to mount and investors demand higher yields, many borrowers decided to abandon their ambition to raise cash for the moment. US sub-investment grade bond yields and spreads rose to a fresh two-year high after the biggest monthly loss in June since the onset of the pandemic in March 2020. Rising market volatility and uncertainty, together with the rising cost of debt, fuelled the worst second-quarter losses and kept borrowers away from the market. Second-quarter issuance slowed to a trickle, with bond sales at a modest $25bn, the lowest 2Q volume since at least 2006. Issuance of high yield bonds has seen a very lacklustre year with numbers down significantly. In 2021 we saw new dollar high yield bond offerings reach $287bn from 420 issuers at this point of the year but so far this year the we have seen only $67.75bn from just 94 borrowers. High grade issuance in June volume was at $10bn, the slowest month since 2010. Syndicate desks missed projections for the third week in a row, selling just $7.75bn in new bonds before the Independence Day holiday weekend in the US. CelaneseUS Holdings delayed a potential jumbo bond offering last Wednesday to help fund its DuPont Mobility & Materials acquisition as volatility flared and issuers struggled to price deals earlier in the week. Monthly June high grade issuance was $69bn versus market expectations of $90bn.
In a period of rising interest rates, it would be thought that index-linked and floating rate notes would be highly popular with investors to safeguard against inflation. However early last month General Motors (GM) dropped its 5-year FRN tranche as floating-rate note showing that demand index-protected bonds beyond 3 years remains modest. The American car maker attempted to launch a 5-year FRN, but investor interest was hard to garner. In the end GM only launched a 5-year bond with a 5% fixed coupon. Issue size of the senior unsecured 5-year bond was a healthy $1.25bn however, with a yield of 5.03%.
The reason for investors lack of interest in inflation-linked bonds protecting them from inflation is mixed and complicated. Thoughts that inflation levels will soon top out and start to recede could be one, breakeven* rates could be another.
*Breakeven inflation rate is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality. If inflation averages more than the break-even, the thought is that inflation-linked investments will outperform the fixed-rate bonds.
Russian default
So, it finally happened. A grace period on around $100m of missed bond payments ended last Sunday. Russia is disputing the default designation however, but the fact is investors haven’t got their cash. This marks its first foreign default since the Bolshevik rejection of Czarist-era debts in 1918. Russia got very near to a default earlier this year but managed a last-ditch escape by switching payment methods. That alternative avenue was subsequently shut off in May when the US closed a sanctions loophole that had allowed American investors to receive sovereign bond payments. Russia had already lost the opportunity to issue dollar-denominated debt and as of now, it can’t borrow from any major international bond markets. Russian sovereign bonds seem to be trading at around 20c in the dollar. Japan’s Government Pension InvestmentFund said today that it’s been selling Russian assets since March following the invasion of Ukraine, marking down some values to almost zero in the process. The world’s biggest pension fund has substantially reduced holdings of Russian bonds, which can still be traded over-the-counter.
Chinese takeaway
The last year Chinese international dollar bonds have had a difficult time to say the least. We saw bonds of Chinese property developer Evergrande default and casino operator Sands China was pushed into sub-investment grade territory.
Another Chinese property developer affected at the time was Country Garden. In September last year we sold a 9-year Country Garden bond we held at around 100.00. Since then, the bond price has done nothing except head south. Moody’s had actually upgraded the company to investment grade in September 2020, however in June this year they knocked the country’s largest property developer back down to a sub-investment Ba1 grade, with a negative outlook. Moody’s cited Country Garden’s ‘declining property sales and deteriorating financial metrics,’ as well as weakened access to long-term funding. Country Garden is a huge company, its $81bn of revenue last year was nearly triple that of America’s largest homebuilder. The company employs more than 200,000 people and has operations throughout China. The current yield on the bond we sold last September is now over 17.5%, a price of 38.00 its lowest ever level.
Becton Dickinson, Cemex and Danaher Corporation all upgraded
American global medical technology company Becton Dickinson was upgraded by Moody’s and Fitch from Baa3 to Baa2 and BBB- to BBB respectively, both with stable outlook. Becton Dickinson had over $19bn in revenue last year with a broad diversification across multiple product categories and countries. Moody’s believe that the company’s low gearing will continue. Its net debt/EDITDA is a low 2.5 times last year. S&P rates the company at BBB stable. Since the rating upgrades the company’s bond prices have recovered a few points.
Also upgraded was Mexican building products company Cemex SAB which was raised by Fitch to just one notch below investment grade. The rating agency upped their senior rating to BB+, outlook stable. Fitch said that: ‘The upgrade reflects Cemex's ongoing stronger operating performance which along with asset sales have supported effective debt reduction since late 2019. The company has been also improving its debt profile, in terms of maturity, collateral basis and financial costs which translate to better financial flexibility. Fitch expects Cemex to solidly maintain its credit metrics below 3.5x in the next 2-3 years while continuing to invest to optimize its portfolio, enhance its business position and advance on its sustainability agenda.’ Since the upgrade the prices of its bonds have remained largely unchanged.
Another medical company to see a rating agency’s approval was Danaher Corp. S&P upgraded the company from BBB+ to A- with a stable outlook. Bloomberg said Danaher’s robust 1Q performance and affirmation of 2022 expectations keep it on a road back to single A status in coming quarters. Its euro-denominated notes don’t fully factor in that view, trading wide to its peers like Medtronic and flat to Stryker and Thermo Fisher. Since the upgrade its bonds have seen an increase of a couple of points.
Credit Suisse CoCo repayment
Credit Suisse (CS) tapped investors for a new $1.65bn 9.75% bond to repay an existing $1.5bn 7.125% AT1 bond with a call at the end of July. It is accepted practice for banks to redeem AT1 instruments at the first opportunity but there have been exceptions, notably Deutsche Bank in 2020, when it decided not to redeem its $1.25bn bond. This was not received well at the time. CS could have done the same, instead opting to issue another bond at a higher price. The old bond’s coupon would have reset at around 8.55%, meaning the new deal cost CS roughly 120bps more than sticking with the old one.
Choosing not to redeem the bond could have raised concerns that the bank might be unable to repay debt as it weathers a turbulent period. CS has had enough problems over the last 18 months so they can’t afford something to go wrong. After trading as high as 102 earlier this year, the 7.125% CS bond dipped to 95.875 before the repayment announcement at 100.00. We could see other banks continue to repay their bonds at their first call date. CS also said that redeeming the outstanding instruments helped it to simplify its AT1 capital portfolio. All its AT1 bonds will now be structured to be written off should capital fall below a certain threshold, as opposed to being converted into equity, as was case with the bond now being redeemed.
The new CoCo bond, which has a rating of B+/BB, has a call in June 2027 with a reset at the 5-15 Treasury yield curve +6.383%, today this would equal 9.633%. Since its launch 2 weeks ago its price has risen 2 points.
Created in the during the 2008 financial crisis, Additional Tier 1 securities aim to bolster a bank's capital buffers and aim to ensure that investors, rather than taxpayers, would be on the hook if a bank ran into financial difficulties.
We have always argued that when banks’ launch callable bonds their intention is to repay at the first call date in the majority of cases, even if it is not necessarily economic to do so, as in this CS case.
Trevor Cooper FCISI
Chief Executive Officer
Chief Investment Officer