Corporate Bond Market Analysis

Three charts that tell traders what look out for in US credit in 2018.

We speak with Edward Casey, independent portfolio manager, about the corporate bond market in the first half of the year, likely trends in the second half of the year and the impact they will have upon execution of investment ideas. Government bond data supplied by MTS.

Dan Barnes Welcome to Trader TV Fixed Income – your insight into the trading climate of professional investors. I’m Dan Barnes. In July’s show we’ll be taking stock of the conditions in the corporate bond market with Edward Casey, an independent portfolio manager. We will look at the dynamics which might affect fixed income investors in the second half of 2018, and then how that might affect their interaction with their trading teams. Monthly government bond data is supplied by MTS Edward, welcome to Trader TV.

Edward Casey Thank you, Dan. Nice to be here.

Dan Barnes So my first question is, how would you characterize investment conditions in the first half of 2018 in credit?

Edward Casey I think for credit and all financial assets, it was really a return to volatility in the market. So we had several challenges facing overall markets here in the United States. We had interest rate policy moving up. We had some dislocations in February around some of the ETF’s having a tough time. And of course, we had the central bank reversing and unwinding some of their balance sheet. I think one of the dynamics that did take place in the first half, that was a challenge, was the correlation of returns. As you think to February, we had an environment where both equities and credit and fixed income in general, all the returns were negative. Historically, credit returns and fixed income returns are negatively correlated to equities. But if you look back over a much longer time period, you can see that there is moments in time where they have been positively correlated. So, portfolio managers and traders today are looking at their portfolios and really trying to structure how they’re positioning, whether it’s deploying, say fx, credit default swaps or other kind of tail hedges to make sure that they create an anchor to windward for their clients, that their portfolio will return positive returns in tougher times.

Dan Barnes And then looking at the second half of 2018, what do you think are gonna be the big dynamics impacting the market?

Edward Casey I think for the second half, probably the biggest dynamic is just the removal of central bank accommodation. When you look at the balance sheets of the 6 largest central banks in the world over a longer time period, looking back over the last 10 years, they’ve expanded by over 14 trillion dollars. And although here in the United States, we turned off the printing presses in late 2014, the other central banks have continued to be accommodative, providing liquidity to the market. And they’ve added about 5 trillion of debt to their balance sheets. And one of the things that’s very important to think about is, if you were to look at the market cap of the equity indices vs the central banks balance sheet expansion, it’s highly correlated. So, I think for the second half of the year here in the United States, starting this month, Federal Reserve will be removing 50 billion pr. month off of their balance sheet. That annualizes to 600 billion dollars, and I think for your viewers to remember, is as recently as 2002, 600 billion dollars was the entire balance sheet of the Federal Reserve. So, we do have an environment where the Fed is trying to raise rates, trying to normalize their balance sheet, and I think this does risk slowing some of the growth here in the United States. And that will be at a time where the boost that we’re getting from the fiscal and tax policies will be wearing off. I think that will continue to be the largest challenge as we look at the second half of the year.

Dan Barnes Which investment themes do you expect to develop?

Edward Casey One of the things to think about is we are now in the second-longest expansion here in the United States, we are a year away from being the longest since 1857. So I think, having a understanding that good times won’t last forever is very important. As credit portfolio managers look to make investments today in bonds that are five years out, I think their analysis really needs to include the potential that these issuers could be in a more difficult time when these bonds are coming due. So I think you just have to include that. I think the other theme that will be very important here in the second half of the year will just be a renewed focus on liquidity. As you think about just the overall trading liquidity in corporate bond markets, the broker-dealer community out here, the Federal Reserve tracks their positions on their balance sheet. Before the great financial crisis they were positioning about 300 billion of debt on their balance sheet. Today that has shrunk down to 20 billion for many reasons, including regulatory reasons. And vs that we’ve seen the corporate bond market here in the United States, whether it’s investment grade and high yield, expand from about 3.5 trillion dollars, to now 7 trillion dollars. So we have a 7 trillion dollar market that’s having liquidity provided to them of about 20 billion dollars. So I think that will very much change the dynamic as we get into – which I exepct to be – a market with more volatility, higher yields. I think we’re going to see traders and portfolio managers really focus on liquidity in their portfolios and how they can create it.

Dan Barnes Which dynamics do you think are going to be most challenging for trading desks to deal with, such as managing liquidity or price formation?

Edward Casey As we see volatility return to the markets and correlations breaking down, you will expect that those desks, whether it be the sell-side trading desk, will be forced to derisk some of their portfolio, and I think that is important. When you look at the bid-ask spreads that are in the market say fx from, MarketAxess, which is one of the electronic, corporate bond, trading platforms that has some great data on historical bid-ask spreads. What we do know is when volatility returns to the market, both the cost of transaction, that is the ‘where you can buy’ vs ‘where you sell,’ and the amount of volume that you can track and execute at that level. Certainly today that cost is very small vs historical. So, I think for traders to be aware that in more difficult times, the bid-ask spreads can widen out and that can certainly influence position. The environment today warrants a more cautious outlook on credit. So, I think for traders, what can really be beneficial for portfolio managers, is that discovery of liquidity, being able to reflect back to the portfolio managers where they’re seeing opportunities in the market. And those opportunities today have really been geared around positioning in short duration bonds with the pull to par. But as these dislocations can take place in the market, they really need to be viewed as opportunities, and that is where, in the corporate trading world, traders are a huge help to the portfolio managers being able to really show them where there are opportunities. So, I think liquidity will be key. I think as we look to position portfolios going forward, it’s OK to under yield a little bit to have that liquidity and cash available to take advantage of these opportunities. As you think about the potential for credit; credit returns are very asymmetric in how they’re structured, the upside is quite limited, the downside quite significant. So, I think today we’re in an environment – to use the analogy – of gardening, where portfolio managers and traders should be looking at their portfolios, they should be pulling the weeds and watering the flowers and having the liquidity and cash available, to really take advantage of dislocations that can happen in the market.

Dan Barnes That’s been great, Edward, thank you very much for coming on Trader TV.

Edward Casey Thank you so much, Dan.

Dan Barnes I’d like to thank Edward Casey for his insights into the market for 2018, MTS for providing our government bond data, and of course you for watching. To catch our monthly reports on other markets or to subscribe to our newsletter go to Trader TV.NET.

Published on July 31, 2018

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