Stephen Thariyan, Global Head of Credit, and Tom Ross, Portfolio Manager, give their views on the move by some central banks to a negative interest rate environment. They believe credit markets generally will not be unduly impacted by recent moves, but highlight risks to the banking sector and the possible drivers of future credit market direction.
Should negative interest rates be viewed positively or negatively for credit?
The first cut by the European Central Bank (ECB) into negative interest rate territory in June 2014 was greeted by the credit markets with much cheer. The European investment grade market saw huge inflows into the asset class over the second half of 2014 and early 2015 as investors flocked to what was perceived to be a low risk asset with reasonable yield, while government bond yields were falling ever deeper into negative territory. High yield bonds were expected to perform better still. However, with the advent of quantitative easing (QE) in March 2015, spreads (the difference in the yield of corporate bonds over equivalent government bonds) widened, flows started to dry up and what had been a wave of buying of European credit assets dropped sharply. Yield fatigue had set in.
As we see further negative interest rates globally, markets are starting to refocus on fundamentals and the credit cycle and move away from a reach for ‘yield at any cost’.
Credit likes a world of controlled growth, not one of concerns over growth. Should interest rates be cut further due to concerns over growth, we would expect to see credit assets continue to underperform.
Which parts of the credit market would outperform in a negative interest rate world?
We had hoped to see high yield bonds in Europe continue to outperform their investment grade counterparts as they did in 2015, due in part to the very low yields available on investment grade assets. Year-to-date in 2016, investment grade has outperformed high yield in both Europe and the US. Weakness in the US high yield market – stemming from low oil prices – has impacted European high yield bonds, while in the investment grade space, bonds have produced positive total returns due to moves in the underlying government bond markets. There is a much stronger link between investment grade credit and interest rate moves, with less duration inherent in the high yield market.
How have consumers and corporates reacted to the negative interest rate environment in Europe?
One of the great ‘white hopes’ of negative interest rates was to spark corporate spending and increase bank lending to generate growth in the economy. However, particularly in Europe, we have yet to see much evidence of this. We believe that Europe continues to be in the recovery phase of the credit cycle and as such corporates are focusing on deleveraging rather than spending. Had companies started to spend more, there would perhaps be less talk about the need for further interest rate cuts.
Which sectors are likely to out/underperform in a world of negative interest rates?
European banks have been particularly hard hit both in the equity and credit markets during the most recent market turmoil. While concerns over the health of this sector are numerous, one of the drivers behind the recent sell-off has been that it is harder for banks to make money in a negative interest rate environment. Low/negative interest rates are less likely to attract savers, and margins are squeezed.
Recent interest rate cuts have also been greeted by flattening yield curves: banks are perceived as being healthier in steeper yield curve environments. Furthermore, spreads on US bank bonds have recently widened as fears have grown that the US Federal Reserve is likely to be on hold for the foreseeable future. Negative/lower interest rates may also impact insurance companies, although to a lesser extent than banks since insurance companies are not as highly geared. Some smaller insurance companies with a large exposure to guaranteed rate products would also likely suffer as negative interest rates would make it increasingly hard to pay these guaranteed yields. Larger, more diversified insurers should be affected to a much lesser extent.
Would an extension of QE to include more corporate bonds matter more than negative interest rates?
A further 10bps cut in the ECB’s deposit rate is unlikely to have a significant impact on credit markets. Should government bonds continue to rally, we may see further positive total returns for investment grade credit. However, it will likely underperform government bond returns on a relative basis.
The piece of central bank action that might produce positive excess returns for the credit markets would be an extension of QE to include more investment-grade credit names, as we saw in late June 2015 from the ECB. We continue to monitor the situation with care.