Good morning!

In an article published at the beginning of the month I was discussing the performance of the fixed income markets and I pointed out that some of the movements look like trading opportunities. Besides the preference for European sovereign paper and long term corporate EUR bonds (including hybrids), which nowadays are likely a consensus trade, I pointed out the attractiveness of the USD bonds but expressed my worry that technical factors have been less supportive in the US market.

To put it briefly, the US high yield market was brought down by its exposure to energy names which, against a backdrop of low liquidity and fund redemptions, had a negative impact on non-energy bonds; on the other hand, the USD high grade bonds experienced an increase in spreads due to strong issuance and higher re-leveraging concerns.

At the moment there are signs that both segments are in a better position. The investors looking for exposure to below investment grade rated bonds have lately disregarded the US market’s exposure to oil-related names and purred close to USD10 billion in US retail high yield funds. In my opinion the trend is easy to explain if we look at the spread differential relative to the EUR market which at the moment is close to 2 percentage points. As a result, the US high yield spreads have rapidly tightened since end-January and reversed the underperformance experienced in January. To put some figures, the spread of US Bank of America High Yield Index tightened from 5.34% on 31st January 2015 to 4.73%; meanwhile the EUR equivalent saw spreads declining from 4.06% to 3.84%.

With the global fixed income markets undergoing a period of falling yields and a number of key central banks boosting liquidity I see scope for further inflows into the US high yield market. I would highlight as well that in late 2014 the B-rated bonds experienced a sharp and quick correction and since then the USD segment of the market only saw a 5% withdrawal in spreads. What is more, the USD B-rated bonds severely underperformed their EUR counterparts so far this year, a trend which is at odds with the divergence in growth outlook. Again, the last two weeks appear to have brought about a change, as the lower rated USD notes rapidly gained ground with spreads tightening 12%.

What is more, I would expect the demand for USD credit to find support in the recent slip in US economic statistics as such data makes the prospect of an increase in US interest rates less likely. More specifically, should the markets become convinced that the Federal Reserve will alter its monetary policy this year, the improvement in spreads could be offset by the rise in US government yields, leaving total returns approximately equal to the coupons earned. However, I am sceptical about the possibility of an early hike in rates given that the depreciation of the USD appears to already act as a drag on manufacturing and inflation while the fall in fuel is not yet translating into higher consumption. Indeed, the Citi US Economic Surprise Index has fallen rapidly in early 2015, sunk into the negative territory and is at a one-year low.

Moving to the Investment Grade segment, for some time now the USD spreads started to look attractive relative to those on offer in EUR (1.3% versus 0.5%) but nevertheless the diverging trend persisted, with the EUR bonds outperforming. As a side note, a similar discrepancy was observed over 2014 in GBP High Grade Rated space, but this reversed in 2015. Judging by the recent performance, the USD market might be next in line; since end-January spreads fell from 1.48% to 1.33% and strong inflows were reported by funds focused on such products.

In my opinion the trend could gradually gather pace as the search for yield persists. In the end, yields are often judged on a relative basis and seeing above-1% investment grade yields becoming increasingly difficult to source in Europe, investors could well come to the conclusion that the USD spreads are a large enough compensation for M&A related risks or other risks associated with a more advanced economic cycle. Furthermore, it is often argued that the divergence in spreads stems to some degree from the larger issuance seen in the US. However, we lately saw large US corporations tapping the EUR market to take advantage of the lower yields; Apple has even moved to issue CHF paper. Thus, the large USD bonds supply might become less of a problem going forward.

Have a nice day!