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  • Trevor Cooper FCISI

Naisbitt King Bond Market Commentary 1st May 2022




  • Inflation and the Ukrainian war continue to dominate.

  • Nowhere to hide – markets prove volatile

  • The consequences of Russia’s attack continue to mount

  • More banks exit Russia

  • Sri Lankan bond default

  • Netflix disaster

  • PEMEX bond repayment

  • New megadeal’s are still appearing


With inflation continuing to spiral upwards and yields tracking higher it has been a tough month for bond investors. In truth it has been a tough month for investors in all markets. April was still dominated by the twin impacts of the war in Ukraine and global inflation. An end of the war is an unknown, but it does look likely that the rate of inflation could turn lower in the second half of the year into next year. The huge rise in U.S. Treasury yields continued to send shock waves through global markets in April with the U.S. 10-year bond rising from 2.34% at the beginning of the month to 2.94% at the end, the highest since 2018. The U.S. economy shrank 1.4% in the first quarter, but the decline was mostly due to a record international trade deficit, lower government spending and a decline in inventories. Robust consumer spending and businesses investment signalled the economy was still steadily expanding.


With low default rates we believe that well-chosen debt securities will show a solid investment opportunity. With many bonds now trading considerably below 100.00 the pull-to-par effect by maturity well show good capital appreciation on top of its coupon yield.


Nowhere to hide


Global central banks’ huge rate rises are seen as on track to try to subdue inflation which has put bonds back in the limelight. It will have to be seen if these rate rises will indeed curb inflation, but the signs are perhaps good. June will likely see the ECB start to raise interest rates and determine an exact end date to its asset purchases. Investors are already pricing in nearly 90bps of ECB rate hike by the end of the year.


The ECB’s first rate hike in over a decade is no big issue for the central bank and the question is rather how fast it should raise borrowing costs further after that, the bank's chief economist Philip Lane said. Inflation in the euro zone hit a fresh record on Friday and investors are expecting the ECB to ditch its policy of negative interest rates and massive bond purchases, which was adopted eight years ago to revive sluggish price growth. We have not held bonds in euro denominated for a few years now, mainly as yields available have been derisory for unhedged portfolios. Since the ECB launched asset purchases in 2014, the German 10-year yield has generally tracked close-to but below the euro-area inflation rate.


Is there any place to hide in these markets? Whether looking at equities, commodities, rates, or Crypto for that matter, they all seem volatile and difficult. We are now looking for a market that will recover first and fast – if there is one? The beast that is inflation could turn start to around later year, credit markets will then start to reprice. Already energy prices look as if they have topped out. Even if they remain high, their inflationary effect will soon start to drop out of the equation. Base effects alone should cause inflation to abate somewhat which in turn could see central banks reduce their rate rises hopefully.


Although the U.S. speculative-grade corporate default rate could double in 2022 to 3% from 1.5% at the end of last year, it will remain at an extremely low level historically. Certainly, stresses are beginning to mount but it seems unlikely we will see it too much of a problem for credit markets going forward.


The consequences of Russia’s attack continue to mount


Russia had foreign-currency and gold reserves of about $604 billion as of March 25. That’s the lowest since August and is down $38.8 billion from a February peak, underscoring the drain since Russia began its invasion. We suspect Putin couldn’t care less.


Last week Russia’s Finance Ministry said it had made payments on two bonds in U.S. dollars, managing to send funds to a paying agent after weeks of struggling with sanctions that cut it off from the financial system and blocked access to dollar reserves. the Ministry said it managed to pay $564.8m on a 2022 bond and $84.4m on a 2042 bond in the currency specified in the documents. The money was sent to the paying agent Citibank, London. Foreign currency bonds for the Russian Federation are now trading around 28.00 for dollar and 18.00 for euro denominated bonds. Russia now faces a sovereign default, but not for lack of cash. Sanctions have blocked Russia’s foreign debt payments and attempts to settle in rubles have been ruled a potential failure-to-pay event.


Russian Railways has now been ruled in default on a bond after missing an interest payment in April, the first such decision since Russia was given extensive sanctions that complicated financial transactions. The nation could still avert a default if it pays bondholders in dollars before a 30-day grace period ends on May 4. A failure-to-pay credit event occurred after a coupon due on March 14 failed to reach investors by the end of a 10-day grace period. Contracts insuring the company’s debt against default will be triggered, and holders will now wait to see how much will be paid. The decision comes as investors focus on whether the country’s sovereign bonds will default after coupon payments on two securities were made in rubles, even though the notes didn’t allow for it. If that happens, it would be Russia’s first external default in more than a century.


I should mention that Ukrainian sovereign bonds have also, unsurprisingly, suffered but not quite as badly as Russian debt. Ukraine has raised more than $1.5bn since Russia’s attack by issuing war bonds. The International Monetary Fund has called on nations to provide grants and donations to fill Ukraine’s $5 billion monthly financing need after Finance Minister Serhiy Marchenko said the economy is expected to shrink between 30% to 50% this year.


More banks exit Russia


Societe Generale agreed to sell its Rosbank PJSC unit to the investment firm of Russia’s richest man, taking a hit of about €3bn to exit the heavily sanctioned nation. Both Raiffeisen Bank International and UniCredit are also considering their future in the country. The three banks are the biggest in Europe with Russian businesses. French banks, including BNP Paribas and Credit Agricole had previously said they would no longer take new business in Russia. In Switzerland, Credit Suisse Group signalled it would take a close look at its wealth management business in Russia and eastern Europe. UBS Group halted new business in the nation and former Chairman Axel Weber said he saw no future for many international banks in Russia even in case of a cease-fire.


Sri Lankan bond default


Our extremely cautious approach to stock picking means we have managed to avoid the worst of the worlds crisis areas. One such area we have avoided is Sri Lanka, which seems to be on the brink of bankruptcy. It is grappling with unprecedented economic turmoil, the worst since its independence from the UK in 1948. This year all the rating agencies have downgraded the country and currently its senior U.S. dollar debt stands at Ca/SD/C (SD – selective default). The country seems to lack sufficient dollars to import essential goods and repay debt at the same time. It now seems likely Sri Lanka will go into a formal default. Working out a possible deal with the IMF could take some time. Sri Lanka’s sovereign dollar debt is now trading around the 46.00 price level including a bond due for repayment just 2 months. Last week Sri Lankan announced its inflation rate had reached 29.8%.


Netflix disaster


Netflix had its market capitalisation hit by over $52bn as its subscribers abandon the streaming service in scores. The Netflix share price is now down 68% this year but its 6-year dollar bond is ‘only’ down 14% since the turn of the year, proving once again that bonds are a less volatile asset class than equity. Although we have never held Netflix bonds in any of our portfolios, plainly its debt has been less volatile that the equity. For the record, that other mega company of the tech sector, Meta Platforms (Facebook), has still not recovered and it share price remains 42% down this year. Even AAA rated Microsoft has fallen, with its shares down 17% this year and its bonds down 8%. We have always been cautious of tech industry bonds, not because we don’t like them, but believing they were too expensive, so we have rarely held them. Facebook and Twitter do not have any public debt.


PEMEX bond repay


Earlier last month Petroleos Mexicanos (Pemex) repaid, on time, their €1bn 1.875% senior unsecured bond. We are carefully monitoring Mexico’s state owned oil company as its bonds fell to fresh lows. The world’s most indebted oil company does retain the Mexican governments support, and it’s believed it will continue going forward. Pemex owes about $2.5bn in principal payments this year, and another $2.5bn in interest. Altogether, the company is on the hook for $5bn in payments to bondholders in the remainder of 2022. The company will resume paying its debt amortizations on its own this year instead of relying on the government to meet the obligations, according to a Finance Ministry official. The Ministry no longer needs to make debt payments because of the extra revenue Pemex is getting from higher oil prices. Senior debt of the oil company is rated Ba3/BBB/BB- negative/negative/stable. This compares to Mexico’s own rating of Baa1/BBB/BBB-, also negative/negative/stable.


We believe Pemex to be an interesting bond proposition, it is one of the world’s largest oil companies and with sovereign backing from Mexico. With its 10-year senior debt now yielding 9% it looks great value to us.


New megadeal’s are still appearing


In the first couple of weeks of April we saw a slowdown in the primary investment grade April market as American banks were reporting. We did see Viterra, Bayport Polymers and Ferguson’s 10-year tranches all garnering modest orderbooks. There were exceptions of course, and despite the yield on the U.S. 10-year going ballistic, Amazon still went ahead with its $12.75bn deal. There was no shortage of investors with the orderbook, at its peak, hitting a mega $40bn for its 7 tranches. It wasn’t all plain sailing through as Amazon still had to pay 10 to 15 basis points in concessions and saw a 40% drop from peak to final order book. The only larger U.S. investment grade deal this year was from AT&T-Discovery’s $30bn megadeal in March which gained an orderbook of $90bn. From mid-week, Bank of America, JPMorgan Chase, Morgan Stanley and Wells Fargo issued debt following their first quarter earnings announcements. Despite a slight slowdown in high grade issuance, by the end of the month we saw $107.2bn, against estimates that called for $95bn. Issuance is expected to pick up next month, with some calling for as much as $150bn new supply. It was a different story for the U.S. high-yield debt market which posted its slowest April since 2009 as rising rates kept investors on the side-lines. As with the investment grade market, the high yield market sees better issuance levels this month.


Croatia’s mid-month sale 10-year bonds was a promising sign for Eastern European issuers even as Russia’s war on Ukraine is still raging. Their €1.25bn deal was the first foreign-currency bond sale since the invasion. Despite doubts the Croatian bond attracted more than €2.65bn of orders and with an original pricing idea of mid-swaps +175bps it came on a spread of +150bps. The spread It has since dropped to +130bps vs. mid-swaps.


Regards


Trevor Cooper FCISI

Chief Executive Officer

Chief Investment Officer

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