Rates and bond stuff
Central banks will have tightened a lot by the time they’re done. But people have been surprised at the resiliency of the economic data in the face of higher interest rates. That may be an illusion. Policy acts with lags. In the US there are signs of slower credit growth and a softening housing market. In time, average debt service costs will rise further. How bad it gets still largely depends on inflation and the central bank reaction function. Any sign of moving to a ‘hold’ would be well received by markets. If not, and with more hikes potentially to come, holding a constructive view on current valuations in the credit and equity markets would become more challenging.
Remember low rates?
The US Federal Reserve (Fed) has already increased its Fed Funds policy interest rate by 450 basis points (bps). Market pricing currently suggests another almost 75bps to come. According to Bankrate.com, the average 30-year fixed mortgage rate has risen from 3% in late 2021 to 7% today. Rates on 90-day non-financial commercial paper (a proxy for the cost of short-term debt to the corporate sector) has risen by more than 450bps in just over a year. All prospective borrowers in the US are facing significantly higher interest rates, with more to come. The Fed has made it clear it will keep raising rates and keep them high until it sees inflation fall a lot lower. The cost of that might still be a recession in the US, as these higher borrowing costs eventually weaken aggregate demand. This narrative can equally be applied to the Eurozone and the UK.
The lags by which tighter monetary policy hits growth are unclear, and often long. It would not be unusual, by historical standards, for the worst of the impact of the tightening to still be ahead of us. There is already evidence of higher rates working. Fed data shows mortgage demand has weakened significantly. A measure of domestic lenders reporting strong demand for mortgages has dropped to its lowest level since the global financial crisis. In the same report (Senior Loan Officer Opinion Survey on Bank Lending Practices, January 2023), the numbers show a tightening of bank lending standards across the credit spectrum (to corporates and households). Almost half of all banks in the US reported a tightening of lending standards, increased spreads for loans over the banks’ cost of funding as well as significant declines in demand for commercial and industrial loans. The credit squeeze is on and is likely to get worse.
The flow of new credit is weakening. Higher rates deter new borrowing which will have an impact on investment and consumer spending. Mortgage demand and housing activity have slowed. The volume of authorised new building permits has fallen by 30% from the end-2021 peak. This suggests fewer new housing units being built, with implications for aggregate residential investment, construction employment and housing-related demand for durable goods. It’s not a disaster. The decline in housing activity as evidenced by housing permits and starts is relatively mild in this cycle so far, compared to previous periods. Between 2005 and 2009, the number of permits fell by 78%; in the late 1980s the decline was 55%. But higher rates are hitting the housing market. House prices have started to roll over.
Is credit safe?
Some of the pushback to our constructive view on credit as an asset class is that spreads don’t reflect the economic risks given the impact from higher rates has not been fully felt yet. The argument is that as borrowing costs increase there will be more stress in the corporate sector and that rating downgrades will increase – and default risk in the high-yield market will rise – and this in turn will lead to a widening of credit spreads from current levels. Wider credit spreads will cause negative corporate bond returns. The current spread duration on the US corporate bond index is just below seven years, which means a 100bps widening of credit spreads would push bond prices down by 7%. The spread today is 130bps but was 170bps as recently as October. There is a risk of spreads widening again if the risk of a slowdown materialises.
Household wealth down
Higher rates are impacting the flow of credit by raising the cost of new debt. The real damage to growth will come if rates stay high enough for long enough to impact the cost of the stock of debt. So far this is limited. In the US, mortgages are generally taken out at fixed rates, so existing homeowners who borrowed before this year have not seen rising monthly mortgage payments. Employment is at record levels and wage growth has been strong. But consumers will start to feel the pinch if a collapse in housing demand hits house prices and leads to a decline in household wealth. Last year saw a significant decline in estimated household wealth – largely because of lower equity and bond markets – which could continue this year with markets continuing to struggle and house prices likely to fall.
For the corporate sector, higher rates are leading to reduced demand for new credit. National accounts data is only available with a considerable lag, but data shows the non-financial corporate sector was in good shape in the third quarter (Q3) of 2022. Net interest payments as a percentage of corporate profits were at a historical low. The ratio of debt relative to corporate profits has fallen steadily since the pandemic and is at one of the lowest levels of the last 50 years according to data from the Fed’s Flow of Funds report. So far, the effects of inflation on profit margins and the normalising of spending on technology are bigger concerns for the US corporate sector than borrowing costs.
Debt costs rise slowly
In the bond market, the average weighted coupon rate for US investment-grade borrowers has risen over the last year. But not by that much. Using the ICE Bank of America US Corporate Index (excluding banks), the average coupon is currently 3.85%. The low last year was 3.65%. On the eve of the pandemic, it was 4%. For the high yield market, today’s average coupon on existing debt is 5.88%, up from a low of 5.67%. Years of very low interest rates in Europe means the average coupon on the stock of outstanding investment-grade debt is just 1.8%. The fixed coupons that corporate borrowers pay on debt don’t go up when central banks raise rates – the cost of debt only goes up when the borrower needs to refinance. A generic European corporate borrower would need to pay almost 4.5% today, according to the current yield on the index. For some, this jump in borrowing costs on refinancing might be a struggle. In the US high yield market, the weakest-rated borrowers face a refinancing rate that is twice the level of the average coupon on existing debt. Some investors may think that a 14% yield, incorporating a credit spread of 1,000bps for CCC-rated bonds, is sufficient to compensate for the risk of companies not being able to afford these elevated interest costs when they do come to refinance maturing debt.
Market is open
Higher rates will gradually increase the average cost of borrowing and cause interest payments to become more of a drain on corporate finances. They may also make refinancing debt more difficult. But given the huge amount of new issuance in both the US dollar and European bond markets so far in 2023, this does not yet appear to be a major issue. There has been some $363bn raised by US corporates in the bond market year-to-date, and a $90bn equivalent by European issuers.
Debt service manageable for now
Bearish views on credit and equities are based on the argument that today’s valuations (spreads and price-earnings ratios) do not fully reflect the risk the ongoing impact of higher borrowing costs will eventually weaken spending and corporate earnings and will impact the ability to borrow at affordable interest rates. It’s a reasonable argument, especially as we are still not at the interest rate peak and the consensus now is that rates will remain high for some time. But at the same time, the denominator in the debt service ratio remains strong. Household income growth is driven by positive employment and wage trends. Corporate sales growth has slowed but in nominal terms it remains strong and earnings before interest, taxes, depreciation and amortisation (EBITDA) are still close to a record high for the S&P 500.
Inflation remains the main concern
Investor confidence levels rely, as they have done for some time, on what happens with inflation as this will determine the ‘high’ and the ‘longer’ for interest rates. The news from Europe this week is not very encouraging. At a Eurozone level, consumer price inflation edged down to 8.5% in February’s preliminary data - from 8.6% in January - while core inflation accelerated from 5.3% to 5.6%. Market pricing of terminal rates has gone up as a result. The European Central Bank’s benchmark interest rate is now priced in at 3.9% with the Fed at almost 5.5%. The longer this goes on, the more difficult it will be for credit (spreads) and equity markets to hold current valuation levels.
Bonds getting cheaper again
Tactically, short-duration fixed income strategies remain attractive in this environment. But, as argued last week, credit looks reasonable from a longer-term view. The average price of corporate bonds is still well below par. There will be a gradual roll up in prices in the bond index which will help deliver positive returns. If the recession does come, focus will turn to rates being cut – the market still has that priced in for 2024. Any easing of monetary policy will generate some retreat from the steep inversion in yield curves that remain a feature of today’s fixed income markets. Such phases of the rate cycle are positive for bond returns. The re-pricing of the near-term rate outlook has also pushed longer bond yields higher with the US Treasury 10-year benchmark above 4% for the first time since November. I argued back then that, from a longer-term fundamental view, 4% is fair value. Let’s see if investors do what they did last autumn and increase their exposure to bonds again. There was a window of about a month back then, when one could lock in a yield above 4%. The market is giving bond investors another opportunity to do so. I don’t think it’s a bad idea to repeat. That 3.5%-4% (ish) range might define the bond market for some time yet.
Manchester United have re-discovered how to win when they’re losing. That is the mindset of trophy-winning teams and has been largely absent from Old Trafford for a decade. The winning mentality, the efficient use of the squad and strong leadership from Erik ten Hag has driven United to win all but two of the team’s last 19 games in Manchester. There are tough games ahead, including Liverpool away and another two-leg European tie against Spanish opponents. But it’s hard to bet against United right now. One down, three more to play for.