Who could benefit from the reflation trade?

It is crucial to start analyzing the possible consequences of the steepening of the interest rates curve.

CIO Letter March

Over the long term, the rhetoric of secular stagnation remains an axiom for most investors. In the short term, the combination of technical spikes in inflation figures and aggressive budgetary policies is challenging the ability of monetary authorities to preserve their inflated balance sheets. Consequently, the possibility of a new taper tantrum is resurfacing.

Interest rates have increased, and curves have steepened. The trend could well continue, with positive news from the Covid-19 pandemic acting as a catalyst by increasing the odds for a faster and stronger growth recovery.

Curves have also steepened during periods of expected recovery in the past. The U.S. 2/10-year curve reached 270 bps in 2003 and 290 bps in 2010. This means that, even if the 2-year rate were to stay where it is today, the 10-year rate could easily reach 2.75%-3.00% by historical standards.

Inflation expectations could of course act as a mitigant: at 2.3%, the current 10-year inflation swap rate could represent an implicit ceiling to a rate sell-off. But a temporary overshoot is still highly likely: during the taper tantrum in 2013, the 10-year rate overshot the 10-year inflation swap rate, with the former trading at 3% versus the latter at 2.45%.  

While this is still a hypothetical scenario, it is crucial to start analyzing the possible consequences of such a steepening for fixed income portfolios.

Obviously, the total return on fixed income instruments will be negative, and not just in the Government bond space. For corporate bonds, the spread component is too thin to compensate for a material Treasury rate increase, as it has been able to do in the past. This is all the more true since spreads are already pricing for a strong recovery environment, and further compression will be challenging. The pressure could even result in a spread widening. The tight spread situation is not only due to lower default rate anticipations, but also to the massive squeeze generated by Central banks through their asset purchase programs, which have created distortion. As such, a tapering by the FED will not only be a negative rate event but also a spread widening one. This effect could also be amplified by the increase in the average duration of the investment grade universe, combining the mathematical effect of lower rates with maturity lengthening from issuers, especially the highly rated ones.

For the time being, the problem is very much U.S.-centric; the European situation does not call for a massive rate repricing. Nevertheless, European credit spreads won’t stay immune if U.S. credit spreads widen. All things being equal, international flows and arbitrage activities should maintain homogeneity across the rating spectrum, whether the currency is USD or EUR.

Sector-wise, financials should be less impacted. A steeper curve is usually positive for banks, and a future higher rate environment should imply higher profitability in the insurance sector. Among the different underlying instruments, additional Tier 1s should benefit the most from the rate normalization, thanks to their equity-like component. However, stocks should be picked with caution as the asset class has already strongly outperformed (5% compared to -23% for the EURO STOXX Banks in 2020).

For more aggressive yield hunters, a competitive place to invest could well be the leveraged loan space. First of all, most leveraged loans are Euribor- or Libor-based (or their new equivalent), with a floor. Consequently, even if the floor feature could theoretically boost the duration of leveraged loans, it remains very low, with no perceptible impact from an interest rate curve steepening. Second, they are not part of any Asset Purchase Program from Central Banks, and unlike corporate bonds their average credit spread remains far from historical lows. Third, in the event of debt restructuring, recovery rates are expected to be higher. Indeed, the challenge for most companies right now is not accessing immediate funding, but recapitalizing a balance sheet affected by 2020 losses. Hence, on the one hand the risk of subordination of existing creditors is low, while on the other, the tremendous amount of dry powder in the Private Equity space makes recapitalization easy. Finally, the CLO machine is up and running with AAA EUR-denominated tranches reaching 80 bps, leaving ample room for the CLO arbitrage to work and to create new inflows in the leveraged loan space.

In the U.S., it is common practice to see interest rate expectations driving fund flows backwards and forwards between high yield bonds and broadly syndicated loans. In Europe, the two markets appear more segregated, with no significant retail money invested in the loan space. But as with bonds, the transmission mechanism between USD- and EUR-denominated loans should play its part and be supportive for the European Loan market.

More than ever, issuer and financial structure selection will be key to navigating in an environment where recovery could be highly heterogeneous between sectors and countries.

 

This article is an opinion article and does not constitute investment advice or recommendations. Neither the author nor SCOR Investment Partners assume any liability, direct or indirect, that may result from the use of information contained in this opinion article.
 

OUR EXPERT
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Fabrice
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Rossary
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Chief Investment Officer, SCOR Investment Partners
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