Uncertain times may bring back a bond market many don’t remember
There’s been no shortage of volatility in recent years, often ignited by one-off exogenous events — regional political uncertainties, the unexpected tone in a phrasing uttered by a central banker — and founded on a prolonged search for yield that has led to a one-sided market.
But the glut of uncertainties has only become broader, deeper and murkier. The result is that risk premia that haven’t been properly priced into securities for years have begun to resurface.
Bankers have noted the return of country risk to sovereign bond pricing in recent weeks, and while event-driven repricings do happen from time to time (think Greece around the time of the referendum), recent moves have been more widespread, as markets come to terms with the possibility of rates rising in the US and profound potential changes to international relationships in the Western world with the election of Donald Trump to the presidency.
With Trump in office, this dynamic is unlikely to change. Though the market seems to like his proposals for huge spending increases, and drastic tax cuts, there are bound to be other uncertainties arising from his incumbency that might drive violent shifts in market sentiment.
The broad return of risk premia to markets for a prolonged period would be a mixed blessing. On one hand, credit has not yet flowed satisfactorily to the real economies of regions like the US, EU and Japan despite an era of low rates.
But on the other hand, as central bankers like Mario Draghi have oft complained, part of the ineffectiveness of easy monetary policy in juicing growth comes down to the lack of political will to engage in structural reforms. No wonder then that, after a brief downturn in markets following the US election result, investors appear to now be embracing the potential of a Trump presidency to put verve back into economic activity.
As one banker recently put it, “Draghi must be thinking, ‘Thank God, at least somebody’s having a go.’”
There are of course big potential downsides to a cut-and-spend approach to the economy, including an increase in the likelihood that the next downturn in the economic cycle will be all the deeper and more painful. But, for now, sovereign yields appear to be expressing enough of a divergence to, hopefully, make politicians sit up, take notice, and put into actions fiscal plans to enhance the effects of monetary policy. Indeed, some onlookers have high expectations for the inclusion of fiscal stimulus in the next Autumn statement in the UK.
But if the trend keeps up, capital markets pros are in for some rude awakenings. It has been nearly a decade since syndicate professionals in many markets — sovereigns being the prime example — have had to do much but launch their deals, wait until books are bulging, price, close and allocate. Many syndicate professionals are about to, for the first times in their professional careers, see clearly that these have indeed not been normal times.
And issuers are going to have to get used to the idea that they won’t always be able to get exactly what they want when they come to market.
For years, an upsetting result was usually one in which the reoffer price of a bond was not as close to the tight end of guidance as a seller would have hoped. In 2017, they may well be in for a market in which the result is occasionally wider than the high end of initial thoughts. Bouts of volatility will cause issuers to pull deals, and they’ll have to reconsider their overall funding strategies, like pre-funding more heavily despite the carry cost, or issuing more frequently in smaller sizes.
Issuers and intermediaries should ready themselves for a rough return to more normal, and more challenging, environment for issuing bonds. It's going to be a bitter pill to swallow in the short term, but it could make a more healthy market in the long run.