Chasing risk in fixed income; the looming maturity wall and the AT1s comeback

Published on 15 January 2024

Sarah Harrison, senior portfolio manager at Allspring Global Investments, discusses her outlook on the market and fixed-income valuations following a shaky start to the year. She also unpacks her views on timing central bank rate cuts, where desks are chasing risk, her concerns on the looming wave of refinancing debt, and whether we’ll see a continued resurgence in AT1 bonds.

North America

  • US equities volumes fell and liquidity worsened, but spreads ranged on average for the same period for the past 2 years. US IG volumes climbed week on week and liquidity improved.
  • Data: Canada’s Inflation Rate is out on January 16 and US Retail Sales are out on January 17. US earnings e.g. Morgan Stanley.
  • Primary Equities: 2 IPOs expected to price at $28.5 million. The largest being HW Electro Co., Ltd.
  • US axe data, which is within normal ranges, indicates a higher proportion of bids versus asks in credit.

Europe and the UK

  • EU equities volumes remain elevated for January, yet, liquidity has worsened. EU investment grade volumes roared back to life, and liquidity has improved week on week.
  • Data: UK’s Unemployment Rate on January 16, UK and EU Inflation Rate is out on January 17, and UK Retail Sales are out on on January 19.
  • There are no IPOs expected on European exchanges again this week.
  • EU axe data, which is within normal ranges, suggests a higher proportion of EU dealer bids versus asks in credit.
  • GBP axe data, within normal ranges, suggests higher net buying versus selling of credit.

Transcript of interview:

Jo Gallagher: Welcome to Trader TV This Week – your insight into how trading desks can prepare for the week ahead. I’m Jo Gallagher. Today I’m joined by Sarah Harrison of Allspring Global Investments to discuss the main topics and events leading into this week.

Speaker 2: Sarah, welcome to the show.

Sarah Harrison: Thanks, Jo, it’s great to be here.

Jo Gallagher: Before we begin, let’s take a quick look at last week’s activity and what’s coming up.

In North America last week’s equities volumes fell marginally week on week, as anxiety in the market amid the January selloff has eased and volumes were near average ranges for the same period in 2023 and 2022. Liquidity worsened compared to the previous week, but bid-ask spreads were still much tighter than levels seen for the same period in January the past five years.

US investment grade volumes climbed week on week, mimicking the high activity we saw in the markets from early to mid-December. Despite the challenging start to the year for IG, liquidity improved substantially going into the second week and bid ask spreads have stabilized and were the tightest they have been for the past five weeks.

This week will be relatively quiet in terms of economic indicators in North America, but we will get the latest reading on Canada’s inflation rate on Tuesday and numbers on US retail sales on Wednesday. We’ll also have a fresh batch of earnings to look out for, including reports from Morgan Stanley, Goldman Sachs, Taiwan Semiconductor and American Airlines. There are two IPOs expected to price this week at $28.5 million in aggregate proceeds. The largest deal is expected to be a consumer goods company, HW Electro, which is seeking to raise $15 million.

US axe data, which is in historical ranges, indicate dealers bids have increased by 9.9% over asks in the past week, suggesting market jitters had eased after the first week of January, as we see a shift back towards buying credit going into the week ahead.

In Europe and the U.K., last week’s equities volumes remained elevated and levels with well above ranges seen for the same week for the past two years. Liquidity has marginally worsened week on week and with the exception of January 2023 levels. Bid ask spreads are much wider than average, as seen for the previous four years between 2019 and 2022.

Last week, European investment grade volumes roared back to life after a slow start to the year, and levels are on par with the highest seen during the December rally. Liquidity across EURO IG has also substantially improved week on week, and bid ask spreads are the tightest they’ve been for the last seven weeks.

We’ll have a busier week in Europe in terms of data, where we’ll have the UK’s unemployment rate out on Tuesday, the UK and EU inflation rate on Wednesday and UK retail sales on Friday. There are few earnings from large cap companies out of Europe this week, but we can expect Q4 numbers from Reliance Industries on Friday. And yet again, there are no IPO is expected to price on European exchanges this week.

EU axe data, which is in normal ranges, indicates the proportion of EU dealers bid versus asks has increased by 13.3%. GBP dealer bids are up by 11.5% against asks for the past week, suggesting a strong leaning towards buying versus selling off credit going into the week ahead.

Sarah, lots to discuss there. How are you positioned going into this week and what will you be focusing on?

Sarah Harrison: It’s been a bit ff a strange start to the year. So we started weaker, but I think that was based more around valuation than fundamentals. We had rally quite aggressively in most, if not all fixed income classes in November and December, and the general market view was that we had gone too far, too fast. And it feels like now that narrative is changing. I think most of us agree the next central bank move will be a cut and not hike. But the questions are firstly, when? And secondly, will you get a better entry point ahead of that move or do you need to chase risk? It certainly seems like after that little wobble at the beginning of the year, we as a leveraged credit market are chasing risk.

Leveraged credit over the past 18 months has become heavily impacted by macro as well as a way to express a macro view. So this week, we are focused around any and all data that will help us to form a view of the timing of 2024 rate cuts in both Europe and the US, versus what is being priced into the market currently. A quick look at the calendar shows that there are a couple of European December CPI prints and initial jobless claims in the US, and that will be the focus for us from a data perspective.

Jo Gallagher: What’s your base view for Europe versus US high yield, and are you concerned about the upcoming refinancing of debt?

Sarah Harrison: So there is a lot of talk in the high yield space about the maturity wall. So 40% of European high yield will come due in the next three years. And 25% of U.S. high yield come due in the next three years. Our view is that in most of these cases, this is issuers being savvy about hanging on to lower coupon debt for longer in a higher rate environment, rather than a sign of impending market trouble.

The proportion of this debt trading in distress, or at above 1000 basis points in spread is minimal, only slightly higher than market wide distress, and a large proportion of these issuers are actually double B rated. Double B rated issuers tend to have better market access and less levered balance sheets, generally speaking. It is crucial to do your credit work on this part of the market because you are taking jump risk, i.e., there is a near-term default trigger in the form of the maturity. So having an extremely well-resourced and deeply experienced credit research team like ours is helpful in navigating this very tricky space.

Investors are understandably concerned about the maturity wall driving defaults higher. But our view is that for the most part, the wall will be dealt with in an orderly manner as rates stabilize and eventually come down. Defaults are likely to be concentrated in companies with the wrong capital structures, and that is analyzable and forecastable.

Jo Gallagher: Where are you finding opportunities in high yield and leveraged loans, and what’s been overlooked?

Sarah Harrison: 2023 in fixed income, even in leveraged credit, was about getting your beta positioning right. There was a yield available everywhere, and your big decisions were on whether and when to be overweight and underweight risk and even trading duration, which we as a leverage credit market have really done for some time.

There’s still a lot of yield on offer in leveraged credit today, but less so than in January 2023. We’ve seen a handful of repricing in the loan market already this year, and high yield market is 130 basis points lower in yield since this time last year.

This year to me is all about idiosyncratic risk. The distressed ratio is high single digits, but default rates are expected to be in the low single digits. Getting your security selection right within that delta is going to be key to generating alpha this year. I’d also say that sub risk looks interesting here, i.e. lower rated bonds and credits with a two tier capital structure. With more clarity and stability in the fixed income market and fundamentals improved from this time last year, there are select opportunities to go down the capital structure and credits that you like that are underwritten.

Jo Gallagher: [?] had a bit of a comeback since last year. How do you see them performing in 2024?

Sarah Harrison: For good reason, post the write down of Credit Suisse, investors have been nervous around the asset class. My view has always been that CS was an outlier bank in an outlier regulatory environment. Some confidence was restored immediately post bail in when the UK and European banking regulators came out and said the situation was an anomaly. But it has taken time for investors to get comfortable with the asset class again. H01 is an off benchmark position for most large pools of capital with traditional credit benchmarks, and yield was available everywhere in 2023. There’s no need to be a hero 2023 with a challenging environment for perps generally with the higher for longer narrative encouraging extension risk.

Now that we potentially have rate cuts on the horizon, some of these instruments look quite cheap. We’ve certainly seen a sizable rally in rates hybrids already this year, and that is a combination of the high yield instrument perps and the high yield sector rates that will likely benefit the most from rate cuts. With the cocoa index now yielding about 8%. As the reach for yield continues investors are going to start looking at this asset class again. And earn it’s way in my view. You need to be careful about how you size your allocation because it is a highly correlated and volatile asset class.

Jo Gallagher: Thank you, Sarah, for your insight and thank you for watching. This has been Trader TV This Week.