Turkey’s Path to Policy Credibility – So Far, So Good
PGIM Fixed Income shares insights on Turkey’s central bank.
Macro
- While the U.S. Treasury’s decision not to extend the majority of its credit and liquidity facilities doesn’t affect our base case forecasts for financial markets or economic conditions, it slightly widens the tail risk in a downside scenario. The municipal loan facility may have been one of the political sticking points of the programs, and although Secretary Mnuchin added that ending the programs would allow Congress to re-appropriate $455B, we continue to place the probability of another sizable fiscal program in the U.S. at 50%.
- Although U.S. economic growth may continue to decelerate through Q1 2021 prior to a potential return to stronger growth in Q2 if COVID vaccines are introduced and deployed successfully, many of the global secular themes in place before the virus—shrinking work forces, decelerating production, and worsening wealth inequality—will also likely return to the fore in a post-virus world. As an example of these secular forces, we would point to the prior peak in total auto sales in China with the declining demand consequently leading to decelerating industrial production in Germany.
- Furthermore, job losses in the U.S. have been concentrated in lower-income cohorts, particularly those in the $20-50k and $60-80k income ranges, while employment in higher-income segments, i.e. $80k to more than $90k, has increased. Meanwhile, assets more likely to be owned by higher-earning households, such as houses and equities, have continued to appreciate in price since the height of the market volatility in March.
- Given the backdrop of secular factors, we see an environment where over-indebted entities may find it harder to delever, and those fundamental prospects may be increasingly reflected in credit spreads. For example, hard currency spreads for Mexico, Brazil, and South Africa traded in the same vicinity as recently as 2018 and gapped wider with the virus outbreak. Spreads for Mexico, which has a relatively stable debt profile, have returned to their pre-virus levels, while those for Brazil and South Africa remain materially wider YTD. Similar divergences across the debt capital markets may create ongoing opportunities for active security selection and sector rotation.
Rates
- In terms of the prospect for developed market rates in a post-virus world, one can look at the 10-year German Bund yield, which traded at -50 bps prior to 2020 and will likely remain near these levels after COVID as well. The global low-rate conditions, including those across the U.S. rate complex, should be reinforced by historically low global policy rates well into the foreseeable future.
- While the $17T+ in negative-yielding debt globally points to the years of rising demand for fixed income assets, we continue to see value in the broader sector, especially given the opportunity to roll down some particularly steep yields curves. For example, six-month Euribor is trading around -51 bps, 10-year Euribor is trading around -26 bps, and 10-year/10-year Euribor is trading around +30 bps.
- From a more tactical perspective, although we’re maintaining long positioning in 5-year through 30-year rates in the U.S., we lightened up on U.S. duration following the recent rally and before this week’s incoming supply. We’ve also reduced our long positioning in the 20-year to 25-year segment of the U.S. curve.
- Mortgages continued to firm last week on steady demand and lower origination. The market-cap weighted Treasury OAS and LIBOR OAS tightened by 3 bps to 30 and 29 bps, respectively. Lower rates did not deter yield buying with most 30-year coupons narrowing from 2-8 bps, with the exception of 30-year 1.5% issues, which widened. The fifteen-year sector lagged 30-year performance. GNMAs were roughly flat to Fannies.
Corporates
- Bolstered by positive COVID-19 vaccine-related headlines and solid demand, U.S. IG spreads tightened by 4 bps last week. The bulk of the spread tightening was in the back-end of the U.S. IG corporate curve, and sector outperformance was led by the chemicals, automotive, and energy sectors. After ending last week at an OAS of 110 bps, the index OAS has now retraced back to its November 2019 level. Given that the current yield on the index is now around 1.85%, combined with our expectation for rates to remain rangebound for the next six to 12 months, we believe spreads could compress further from current levels, possibly below the 80 bps range in 2021.
- Primary market activity exceeded expectations, totaling about $35B from 31 issuers. Order books were three times covered and priced with average concessions of 3 bps. New issue activity is expected to remain light this week, with dealer forecasts calling for about $5B of supply. Although issuance will likely remain subdued through December, it’s possible we see an uptick in tender and exchange activity as issuers look to reduce coupons on outstanding debt.
- Despite a strong start to the week, concerns about the virus resurgence and related near-term economic disruptions eventually weighed on European IG market sentiment. European IG spreads tightened by 3 bps last week, ending at an index OAS of 96 bps, which is only 3 bps wider on the year. Although our short-term outlook on the European IG market has become slightly less bullish, we believe it’s possible European IG spreads tighten below 80 bps next year as well.
- The primary market remained busy, with supply totaling €9B. Order books were 3.1 times covered, and performance on the new issues was generally lackluster. We expect a busy start to the week in the primary market before slowing ahead of the U.S. holiday. We believe we could see a pickup in front-end tender activity, accompanied by longer-dated issuance heading into year-end. The M&A pipeline within European banks remained active last week, evidenced by BBVA’s announcement to dispose of its U.S. business and engage in talks to acquire its domestic rival Sabadell. Spreads of several second-tier institutions tightened with the uptick in M&A activity.
Emerging Markets Debt
- Emerging Market assets posted positive returns last week on the back of positive vaccine news, higher commodity prices, and strong inflows. Monday’s news from AstraZeneca and the University of Oxford provided a further tailwind as emerging markets are expected to be the biggest beneficiaries of a vaccine that does not need to be stored in subzero temperatures. Last week, EM hard currency returned +0.46%, EM corporates returned +0.58%, hedged local rates returned +0.19%, and EMFX returned +0.80%. EM hard currency spreads widened by +3 bps as a heavy new issue calendar weighed on spreads.
- Fund flows remained positive, totaling +$3.55B last week. Hard currency funds saw inflows of $1.08B and local currency funds saw an inflow of $1.84B. This brings year-to-date total flows into EM bond funds to -$7.22B, with hard currency, local currency, and blend strategies accounting for $9.0B, -$15.9B, and -$341M, respectively. EM equity funds saw $7.2B of inflows.
- Within sovereign credit, Africa outperformed last week as a weaker U.S. dollar and lower U.S. real rates led to tightening in Nigeria, Angola, and Ghana. Turkey also tightened after its central bank raised interest rates by 475 bps to 15% and simplified its monetary framework. Ecuador lagged after presidential candidate Andres Arauz said he will disregard the $6.5B deal with the IMF if elected.
- Within local rates, the index yield tightened by 2 bps to 4.34% with higher-yielding countries such as Turkey, Peru, South Africa, and Indonesia outperforming. Indonesia bonds benefited from a surprise rate hike by its central bank. We continue to believe that if currencies remain stable and the back end of the U.S. Treasury curve remains rangebound, local currency funds should continue to see inflows for the remainder of the year.
- Within EMFX, recent laggards outperformed last week with the Russian ruble, Brazilian real, and Peruvian sol among the biggest outperformers. Notably, more central banks have been expressing discomfort with the appreciation in their currencies. For example, South Korea and Thailand recently introduced measures to slow the appreciation in their currencies.
High Yield
- U.S. high yield returned +0.62% last week on positive vaccine news. Investors continue to weigh increasing virus cases and the impact of additional restrictions against the development and potential distribution of an effective vaccine. Average yields declined -17 bps, dropping below 5% and ending Friday at 4.88%, while spreads tightened -14 bps to 449 bps.
- Lowest quality tier credits outperformed, with CCC-rated bonds (+1.12%) outperforming Bs (+0.47%) and BBs (+0.61%). Virus-impacted sectors outperformed, with airlines, aerospace, retail, energy, media, and lodging performing the best. Healthcare, cable, and telecom lagged.
- While inflows into high yield mutual funds moderated to $776M, high yield primary activity picked up. Last week, $15.5B was priced across 15 deals, taking month-to-date volume to $25B and year-to-date gross and net issuance to $413B and $139B, respectively. This is above 2013's historical record of $399B of gross issuance. Notably, cruise operator Carnival Corp. placed an unsecured, cross-border bond offering, which priced tight of initial talk and traded well above issue price on the break.
- U.S. leveraged loans returned +0.23% last week, with CCC-rated loans once again outperforming on the back of COVID-impacted names. The primary calendar remained robust, with $8B in new deals pricing last week and another $8-15B expected to price in the coming weeks. Despite a heavy new issue pipeline, strong CLO formation continues underpin demand for the asset class, with last week's selling met by ramping CLOs and high yield funds looking across markets for paper.
- In Europe, high yield bonds returned +0.80%, with spreads tightening by -18 bps to 397 bps. By quality, BBs, Bs, and CCCs returned +0.68%, +0.88%, and +1.74%, respectively. Loans returned +0.62%, bringing the year-to-date total return to +1.74%. We remain constructive on both high yield and loans given our expectation that defaults will remain low and expect spreads will continue to tighten through the remainder of the year and into next year. In high yield, we currently expect defaults to be 2-3% and for spreads to test their post financial tights of 270 bps some time in 2021.
Securitized Products
- Driven by two new issues, U.S. conduit CMBS spreads tightened by 2 bps last week. We expect both secondary supply and new issue origination to be limited for the rest of the year. We continue to favor senior, well-enhanced CMBS tranches as the virus continues to loom over CRE fundamentals.
- Secondary CLO spreads tightened across the capital structure last week on increased demand from credit funds and asset managers. Primary market spreads tightened despite some weakness in underlying collateral. We anticipate robust primary issuance volumes with over 100 deals being marketed across the U.S. and Europe. We believe net issuance may exceed pre-COVID estimates for 2020 as new issue production remains robust. U.S. CLO primary spreads for higher quality portfolios ended at about ~3mL+122/160/230/365/720 bps for AAA/AA/A/BBB/BB, respectively.
- ABS spreads tightened last week as $5B of new issuance was met with strong demand. Technicals remain positive amid broader market stability and persistently low supply relative to expectations. We remain cautious on fundamentals, which have held in well recently, but remain mindful of the future impact of public health/stimulus outcomes. We maintain a preference for senior and subordinate securities, which present upside to pre-COVID levels.
Municipal Bonds
- Municipal bonds traded with a solid tone last week amid strong inflows and limited new issuance. Year to date, the high-grade portion of the benchmark index has now returned 4.42%, and the high-yield portion has returned 2.63%. Along the 5-, 10-, and 30-year portions of the AAA-rated muni curve, the muni/Treasury yield ratios ended last week at 57.0% (down from 65.0% the prior week), 85.7% (down from 91.0%), and 91.5% (down from 93.9%), respectively.
- Municipal bond funds saw net inflows of $1.3B last week. Long term, high yield, and intermediate funds reported inflows of $960M, $369M, and $6M, respectively. Year to date, inflows now total +$31.1B. Meanwhile, month-to-date issuance totals only $18B, including $5B in taxable issuance, which is 58% lower year-over-year. This week's calendar is estimated at less than $2B.
- The U.S. Federal Reserve's Municipal Liquidity Facility (MLF) is set to expire on December 31, 2020. Introduced in April, the program was viewed as a positive for the market, but given its pricing structure it only made sense for lower-rated issuers and, to date, only the State of Illinois and the New York MTA has borrowed from the facility. Meanwhile, the municipal bond market remains wide open. Therefore, we believe the facility's expiration will have minimal impact on the market.
Source(s) of data (unless otherwise noted): PGIM Fixed Income as of November 2020.
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1038861-00016-00 Ed: 11/2020
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