Bank regulatory framework hard at work

Over the past month, the summer rally in corporate bonds post-brexit continued as the ECBs operated its corporate bond buying program (CSPP). On the Euro market, investment grade bonds posted returns of nearly 3% over the months of July and August, while high yield had a performance of almost 4% over the period. The hybrid, junior insurance and contingent capital debt rebounded over the course of the month following the release of stress tests and the recent favorable regulatory measures regarding Pillar 2. On the USD market, the investment grade segment posted a performance of 1.7% over the months of July and August while the high yield market appreciated by nearly 5%. Energy and basic materials sectors outperformed thanks to the stabilization of oil prices. There was a strong supply in investment grade bonds, double that of historical levels recorded in August, reaching $100 bln. On the high yield sector, on the other hand, supply was fairly flat.

Bank regulatory framework hard at work

On the regulatory front in Europe, we witnessed some developments as the risks on the coupon cancellation of bank contingent convertibles abated thanks to a change in the way the ECB sets capital requirements. The central bank is reducing the capital burden of banks by replacing a portion of its binding requirements (in terms of coupon payment) with non-binding guidance. It will also specify that banks will not have automatic restrictions in Additional Tier 1 (AT1) coupon payments when they incur a loss. This would give flexibility to the bank and is in general positive for the AT1 market. Furthermore, the results of the stress tests for 2016 were satisfying for most of the European banks.

CSPP in full swing… 

The ECBs corporate bond buying program (CSPP) has been running above expectations at roughly Eur. 7-8 billion per month. The strong supply in euro investment grade bonds has been well absorbed and there is hence ample support for the      credit markets. However, the rally in bonds eligible for the ECB program is fading, thereby impeding any sharp spread widening and reinforcing the “search for yield”. The primary market continues to offer some risk premium while secondary market is illiquid and very expensive.  

…CBPP3 waning

The ECBs covered bond purchase program (CBPP3) on the other hand has been decelerating dramatically in favor of the CSPP and is close to the end of its life cycle. Despite a surge in Q1 2016, net supply in the covered bond market is still negative. Moreover, currently 74% of covered bonds are carrying negative yields. As a result, there is no more value in the European market. 

Value in European HY market

European high yield market is benefiting from better fundamentals than the US market, where risk premiums appear to be tight on a leverage-adjusted basis, and close to lows of 2011. Due to the relatively high percentage of B- and CCC bonds, i.e. low rated issuers in the US amounting to 27% vs 10% for Europe, the market appears to be more vulnerable to a change in FED policy. Even if rate hikes were to be gradual and meek, it could drastically raise the interest burden of those with the weakest credit quality profile. With this in mind, the European high yield asset class remains an attractive one in an environment that is otherwise starved for yield.   

Convertible bond landscape

European convertibles had a strong performance over the course of August and the uptick in the equity markets did support the asset class. Technical factors appear to be positive, with increased issuance levels from European players even though the market continues to be dominated by US companies. Furthermore, implied volatility is at fair levels and net supply is negative which strongly supports valuations. There were however some outflows that were witnessed as a result of the “risk-off” sentiment brought in by the Brexit.