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Technical Drivers Persisting

28 February 2017 by Mark Holman

Having booked a few profits in early February to give ourselves some firepower for any future rise in credit spreads, we have continued to observe the strong technical picture dominate fixed income flows ever since.

Flows into higher yielding fixed income fund sectors have continued to be positive, while issuance has continued to be muted, especially in those sectors that we have favoured as 2017 top picks, namely bank capital and European CLOs. In addition, there have been a number of positive catalysts in certain stocks, such as buy backs or credit events that have given reason to book profits on fixed income trades so far in 2017. This too has contributed to the high cash and near-cash balances that have contributed to this extended technical picture.

By way of an example, the European High Yield Bond market has shrunk by €7bn since the end of November, in percentage terms that’s around 3%, which coupled with coupon flows over 3-months equating to another 1.5%, it’s easy to see that inflows on top of this can become a powerful market driver. The current new issue pipeline does not indicate much in the way of change either, with new flows dominated by refinancing rather than outright new financing. So in the absence of any material negative news, spreads can be expected to continue grinding-in to levels last seen in June 2014. In Euro HY we are within 5 bps of the tights, in US$ HY we are just 30bps away, however in STG HY, where there is a Brexit premium embedded in spreads, we are still over 100bps away from the spread levels seen in June 2014.

So what will derail this spread compression? Well, with technicals this strong it needs to be something material. In our view that material event is most likely to come from some political event, whether a policy mistake from President Trump, or election jitters in Europe. So far though, these have not filtered through, and the technicals are running out easy winners against fundamentals. From our perspective though, we still have decent exposure to the tightening and remain happy to have taken some chips off the table with good execution in these strong markets, as when or if they turn, it may not be so easy to reposition.

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