In the recent market turmoil, corporate bonds seemed able to sustain their values. Could we assume that in a future market turmoil they will continue showing signs of immunity? Last two times we saw an equities correction (summer of 2015 and early 2016), anxiety dominated the bond markets, especially the high yield market, where appetite evaporated.
One reason that the corporate bond market and especially the investment-grade bonds have held their ground is that relative to this time last year, the issuance of new bonds has declined by 25%. Therefore, we could say that the corporate bond market resilience is based on fundamentals: demand exceeds supply. The built up of excess cash keeps bond prices pretty stable and thus spreads have not widened.
At the same time, we need to be paying attention to the progression of the credit cycle, especially as central banks reduce their purchases and their bond holdings. Under normal circumstances, we should have expected more bond issuances as rates are expected to rise which should lead to widening spreads. Moreover, if yields on international bonds rise, then the appetite for US paper may decline (especially when we take into account that foreigners may want to hedge their dollar exposure). However, the fact that multinational companies plan on repatriating lots of cash back to the US, will enhance their current position of issuing less debt which should keep things pretty calm especially in the investment-grade bond market.
The excess cash sitting in foreign accounts (especially for tech companies) in some cases (such as Apple’s) represent close to 20% of its market value. Nice cushion/insurance as Steve Jobs used to say, but a bit excessive, given the low yields that they generate. A significant increase in yields will lead to capital losses which in turn will reduce operating profits. Sitting on a lot of cash represents capital inefficiency. Financial engineering led companies to borrow in order to do buybacks and raise dividends, but the new tax law and the forthcoming cash repatriation will most probably reduce this kind of capital inefficiencies.
However, correcting for capital inefficiencies at a time of relative stability in the investment-grade debt market does not automatically translate into higher valuations for equities for the following reasons:
- The greater the realized market return has been the larger the range where the market could fluctuate within. To state it differently if the S&P 500 has gained 20%, the range it will move the following year will be wider than if it had gained only 10%.
- As volatility rises the range becomes wider.
- The built up expectations enhance volume trading which in turn adds to volatility and contributes to an even wider range.
- When at the same time there is interest rate anxiety (as expected at this stage of the credit cycle), some sense of market overvaluation, trade uncertainties, and geopolitical tensions, then the mix of those factors create range instability and hence wild swings could be observed on a weekly if not on a daily basis.
Based on the above, it seems that the market could possibly swing more than 35% this year from its 2017 closing. That could put the S&P 500 between 2206 and 3145, which in our humble opinion might too much of a swing for a portfolio with medium risk profile.
Therefore, and until the circumstances change, we tend to opt for a more defensive position in portfolio holdings until the economic and financial horizon becomes a little bit clearer.
Corporate Bonds, Excess Cash, and Market Yields: Is there an Equities Link?
Author : John E. Charalambakis
Date : March 1, 2018
In the recent market turmoil, corporate bonds seemed able to sustain their values. Could we assume that in a future market turmoil they will continue showing signs of immunity? Last two times we saw an equities correction (summer of 2015 and early 2016), anxiety dominated the bond markets, especially the high yield market, where appetite evaporated.
One reason that the corporate bond market and especially the investment-grade bonds have held their ground is that relative to this time last year, the issuance of new bonds has declined by 25%. Therefore, we could say that the corporate bond market resilience is based on fundamentals: demand exceeds supply. The built up of excess cash keeps bond prices pretty stable and thus spreads have not widened.
At the same time, we need to be paying attention to the progression of the credit cycle, especially as central banks reduce their purchases and their bond holdings. Under normal circumstances, we should have expected more bond issuances as rates are expected to rise which should lead to widening spreads. Moreover, if yields on international bonds rise, then the appetite for US paper may decline (especially when we take into account that foreigners may want to hedge their dollar exposure). However, the fact that multinational companies plan on repatriating lots of cash back to the US, will enhance their current position of issuing less debt which should keep things pretty calm especially in the investment-grade bond market.
The excess cash sitting in foreign accounts (especially for tech companies) in some cases (such as Apple’s) represent close to 20% of its market value. Nice cushion/insurance as Steve Jobs used to say, but a bit excessive, given the low yields that they generate. A significant increase in yields will lead to capital losses which in turn will reduce operating profits. Sitting on a lot of cash represents capital inefficiency. Financial engineering led companies to borrow in order to do buybacks and raise dividends, but the new tax law and the forthcoming cash repatriation will most probably reduce this kind of capital inefficiencies.
However, correcting for capital inefficiencies at a time of relative stability in the investment-grade debt market does not automatically translate into higher valuations for equities for the following reasons:
Based on the above, it seems that the market could possibly swing more than 35% this year from its 2017 closing. That could put the S&P 500 between 2206 and 3145, which in our humble opinion might too much of a swing for a portfolio with medium risk profile.
Therefore, and until the circumstances change, we tend to opt for a more defensive position in portfolio holdings until the economic and financial horizon becomes a little bit clearer.