Uncategorized
Falling volatility, rising M&A risk
admin | February 15, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The Fed has not only tamed the rates markets so far this year, it has calmed the volatility markets, too, with implied rate volatility off sharply since the start of January. All of this helps agency MBS and corporate credit, but the corporate market still faces risk from M&A. Companies with balance sheet room to take on more leverage without losing an investment grade rating have helped push up M&A volume quickly this year. That should weigh on aggregate corporate performance.
The MOVE index of interest rate options across the yield curve has dropped 17 points since the beginning of January and hovers just above recent record lows (Exhibit 1). Problems with US-China trade negotiations or Brexit could push volatility up. But if both of those play out in an orderly way, implied volatility this year could set a new record low.
Exhibit 1: Implied rate volatility has dropped this year close to recent record lows
Note: MOVE Index. Source: Bloomberg.
A flat yield curve and low volatility should help all spread products, agency MBS especially. A flat curve takes away potential gain from rolling to shorter maturities, so the wide principal window of MBS becomes less of a liability and spread becomes a more important source of fixed income portfolio return. Lower volatility trims the cost of MBS hedging. Agency MBS could lose some sponsorship this year if the Fed approves proposed bank liquidity rules that relax incentives to hold agency MBS. And agency MBS could come under some pressure later this year as the usual seasonal rise in loan originations pushes more net supply into the marketplace, but the net supply risk looks modest. Spread should leave agency MBS well ahead of duration-matched Treasury returns this year.
Performance in corporate debt should get a lift from low volatility and a flat curve, too, but M&A poses a risk. North American companies have announced nearly $300 billion in M&A so far this year, according to Dealogic, slightly ahead of last year’s $276 billion at this point. Last year ended up as one of the most active for M&A since the 2008 financial crisis, and incentives for M&A clearly remain in place. Growth from new products or expanded markets remains elusive in many sectors, and years of cost-cutting have left little room for more. M&A holds the promise of further efficiencies but also adds leverage to balance sheets. The most likely candidates are companies that can add debt without threatening investment grade ratings. But that should still drive up the continuing concentration of risk in ‘BBB’ balance sheets and widen aggregate investment grade spreads. Corporate debt may still outperform Treasury debt, but it stands to lag behind agency MBS.
* * *
The view in rates
Rates look very likely to drift in a narrow band for the foreseeable future. The Fed has taken away the pressure for higher yields that drove the market last year. US growth looks likely to slow in 2019, and growth in Europe also looks challenged. With 10-year rates in Germany at 0.10, in Switzerland at -0.335 and Japan at -0.032, the US looks like a relative buy. Foreign flows could pull US rates below neutral.
The view in spreads
More investors anecdotally have started shopping for carry, and a number of insurers continue to rotate out of credit and into credit risk backed by consumer balance sheets. A stable Fed should keep encouraging carry trades and that should help performance of both corporate debt and MBS. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt.
The view in credit fundamentals
Household balance sheets look strong, and corporate balance sheets look vulnerable. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. Of course, this all can continue for a long time if growth persists. The Fed has signaled that it stands ready to buffer any material softening in growth. Still, corporate management may need to trim equity buybacks and reduce debt.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
