Inflation Rekindles Niche Market for Duration-Proof Credit

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A corner of Europe’s credit market is luring investors as the threat of rising government yields fuels demand for assets that can protect bond holdings from the risk of interest-rate hikes.

Floating-rate notes, bonds with variable coupons as opposed to the fixed income attached to most debt, have seen a rise in issuance over the past month. The coupons are tied to market rates, so the debt’s underlying valuations are protected if monetary policies shift.

More than half of the $13.1 billion in FRNs sold by investment-grade private sector borrowers this year were launched in the last four weeks, according to data compiled by Bloomberg. That’s almost three quarters of the securities sold in the year since the coronavirus turmoil in March 2020. Bank of America was the latest issuer, with a 1.5 billion euro ($1.83 billion) tranche on Monday.

“We would definitely like to see more,” said Stephan Ertz, the head of credit at Frankfurt-based Union Investment, which oversees 386 billion euros ($471 billion) and a recent buyer of FRNs. Duration, or price sensitivity to changes in yields, has become a hot topic in the corporate bond market and FRN’s offer a way of “getting out of duration risk,” according to Ertz.

Renewed Interest

Until recently, investors had little reason to bid for floating-rate debt, given that central bank support was driving a rally in credit. But bets a post-pandemic economic recovery will unleash inflation is boosting yields on government debt, and that’s now hammering fixed-rate bonds.

At the end of last week, around 80% of this year’s new corporate bonds were indicated below their issue price. Yields on 10-year German government bonds rose a further 3 basis points on Wednesday to minus 0.08%, the closest they’ve been to a positive value in two years.

Citigroup Inc. strategists Hans Lorenzen and Chris Chapman cut their recommendation on long-duration euro corporate bonds straight to underweight from overweight on Monday, as a rise in rates pressures valuations, particularly on longer maturities.

Fixed-rate corporate bonds stretching 10 years or longer have lost almost 5% this year, based on Bloomberg Barclays indexes. In contrast, a Bloomberg Barclays euro floating-rate index is marginally up.

Investors rushing to ditch duration risk in recent weeks have also been switching out of funds that buy high-grade bonds with long or intermediate maturities in Europe, in favor of shorter-dated debt, according to Bank of America strategists citing EPFR Global data on flows for the week to May 12. Prices of short-dated bonds are less prone to dropping when yields rise.

Niche Market

For all their advantages in a rising rate scenario, floating-rate notes remain a small part of the credit market.

Before the current uptick, issuance had slowed to a trickle due to a combination of low fixed funding costs and uncertainties over the transition from Libor, the rate underpinning most notes. The drought was so acute that corporate index providers had to rewrite their rules as they were running out of bonds to track.

But they’re becoming popular again, with investors such as Ertz at Union Investment seeking to buy more FRN bonds as havens against rising rates, ideally from a greater variety of issuers.

“So far it’s been mainly financials, but corporate floaters from industrials and utilities would also be welcome,” he said.

©2021 Bloomberg L.P.

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