Lidia Treiber, Director, Research, WisdomTree | Bond markets this year have been driven by the fear of higher ‘inflation’, drawing some parallels to the fear exhibited during the ‘taper tantrum’ in 2013. Investor behaviour is hanging on the back of economic data and whether the data beats market expectations. As we begin to emerge from the covid-19 induced crisis, investors are struggling to draw clear parallels with past crises. Due to the unprecedented nature of the crisis, data is providing the most reliable insight to the market. As US data prints related to personal income, personal saving rates and wage growth provide an immediate pulse on the state of inflation in the US, investors continue to ponder whether inflation will be transitory or longer lasting. We call the current moves on government bond yield curves, the ‘inflation fear tantrum’.
Rising Treasury yields create a repricing of bonds and lead to a bond universe that should offer more compensation to investors in the form of higher yields. However, if we look at high yield and investment grade corporate bonds, we see that credit spreads1 have fallen since the start of 2021. Here investors are generally being compensated less for the risk they are taking with these bonds. When credit spreads fall, investors increasingly seek relative value trades where exposures to certain asset classes can offer a yield pick-up compared to other segments in the bond market.
The potential for a pick-up in inflation has started to spook some investors. The prospect of a rising rate environment has become an unsettling prospect for investors. With credit spreads falling this year, the hunt for yield is becoming a more pressing concern. One asset class that has traditionally been overlooked but has shown resilience when interest rates increase is Additional Tier 1 Contingent Convertible Bonds (AT1 CoCos) – mainly issued by European banks.
If we consider how AT1 CoCos have behaved during periods of large moves in bond yields, it becomes clear that not all fixed income assets behave in the same way when Treasury yields move. The great bond sell-off in 2015 and the Trump reflation sell-off in 2016 are worth considering, among others. During these periods, when US Treasury yields rose, AT1 CoCos were able to offer diversification by providing better returns than many other areas of the bond market.
AT1 CoCos have now started to pique investor interest given the relative yield pick-up versus European high yield corporate bonds. Credit spreads can say a lot about the market’s perception of credit risk and the average credit spread of major banks today is significantly lower than a year ago 2.
Sentiment around banks has changed in the past year. Markets, previously nervous about the impact lockdowns would have on the banking system, are now more comfortable with the sectors outlook. While the banking sector still faces falling revenues and higher loan loss provisions stemming from the pandemic, capital ratios3 for European banks were generally higher at the end of 2020 than the prior year. If actual bank losses are lower than initially expected, we could see a rebound in profitability.