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King Cash Threatens Credit Market Reign From U.S. to Europe

Investors reaching for yield are now finding it’s less of a stretch.

King Cash Threatens Credit Market Reign From U.S. to Europe
New British one pound coins fall into a container. (Photographer: Jason Alden/Bloomberg)

(Bloomberg) -- Investors reaching for yield are now finding it’s less of a stretch.

Global credit markets are on the cusp of a post-crisis regime shift as higher rates on short-dated U.S. Treasuries challenge the investment case for high-grade corporate bonds -- on both sides of the Atlantic.

Consider this: The Vanguard short-term corporate bond exchange-traded fund, which holds U.S. investment grade debt with a maturity of less than five years, now has an indicated dividend yield only 0.54 percentage point above that of the three-month Treasury bill. That represents a tiny pickup compared with a whopping 2 percentage points in early 2017.

King Cash Threatens Credit Market Reign From U.S. to Europe

For Citigroup Inc. strategists including Joseph Faith and Matt King, that dynamic suggests an asset-allocation shift looms -- with possible reverberations across the euro area.

"Ever since the financial crisis, IG in particular has benefited from investors taking refuge from low or negative deposit rates and from negative real yields on risk-free assets," strategists at the U.S. bank wrote in a recent note. "The rise in real yields has further to go -- with potentially negative implications for risk assets."

With 12-month dollar Libor at 2.46 percent, compared with a paltry 3.7 percent yield for U.S. investment-grade obligations with a modified duration of 7.5 years, there’s a "real risk" money will flow out of the asset class, according to Citi.

Think that’s just a U.S. story? Think again. Euro credit markets are more sensitive to the trajectory of real yields in dollars than they are to similar shifts in the single currency as funding in the greenback remains the benchmark for the global hunt for yield, according to Citi.

King Cash Threatens Credit Market Reign From U.S. to Europe

Another challenge for the asset class: flows often follow performance.

Higher bond yields have roiled total returns for U.S. and euro area credit investors so far this year -- calling into question the sustainability of the mammoth $600 billion cumulative inflow into high-grade funds over the past five years, according to Citi.

That doesn’t mean credit markets are set for a world of pain. Monetary stimulus and the diminished allure of U.S. bonds when taking into account currency-hedging costs is firming up the domestic bid for corporate obligations in the single-trading bloc, which is at an earlier stage of the business cycle than the U.S.

Suki Mann, an independent fixed-income analyst, for one, downplays the bearish case, citing stubbornly negative money market rates in the euro area and the structural demand for the asset class.

"It’s not a case of one month’s bad performance allows investors to pull money out of funds," the former chief credit strategist at UBS Group AG says. "Not everyone is a total-return player. There are many benchmark funds, where spread performance matters."

Supply season

And even as a seasonally strong month for issuance looms in the U.S., Bank of America Merrill Lynch credit strategists remain confident that total issuance will fall 16 percent year-on-year -- diminishing the downside risk for U.S. high-grade debt. Further bolstering their case for subdued supply: The shrinking spread between the cost of debt relative to equity to a level not seen in more than a decade.

King Cash Threatens Credit Market Reign From U.S. to Europe

"While debt remains cheaper than equity, we think this meaningfully large increase in the relative cost of debt incentivizes companies to use relatively less of it," wrote a team led by Hans Mikkelsen.

All told, however, pressure points are building up on high-grade obligations, which have long benefited from the frenetic post-crisis hunt for yield, Citi concludes.

"If the negative total returns and rise in dollar rates and real yields continues, such a tipping point may yet be closer than many market participants think," according to the report.

To contact the reporters on this story: Sid Verma in London at sverma100@bloomberg.net, Luke Kawa in New York at lkawa@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Joanna Ossinger, Brendan Walsh

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