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.
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.
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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.
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