The great bonds-to-equity rotation: myth or reality?

Two-thousand and sixteen ended with many heralding the so-called great rotation out of bonds and into equity. The 30-year bull bond market was coming to an end and investors, en masse, would shift their cash out of fixed income and into stocks, or so the theory goes.

The turning point was Donald Trump’s surprise victory in the US presidential race. His promise to cut taxes and regulation and launch a $1000bn fiscal stimulus sparked a turnaround in investor sentiment. Buy-side firms believed the end of lower-for-longer interest rates was at hand, and wanted out of safe but low-yielding fixed income so they could bet on growth, inflation and rate rises.

The effect on the markets was immediate. In the weeks following the November 8 election, the US’s four major equity indices (S&P 500, Dow Jones Industrial Average, Nasdaq Composite and Russell 2000) reached record highs, while 10-year US treasury yields hit a two-year high of 2.597%. But the real evidence of so-called Trumpflation was found in bond and equity fund flows. Data from analyst EPFR Global shows that in the week ending November 16, $17.81bn left bond funds globally (the highest outflow in three years) and global equity funds saw inflows of $27.55bn (the highest in two years). According to Société Générale analysis, this $46bn disparity is the widest ever.

History repeating

The question of whether this is the great rotation in action is not a new one. Since 2011, commentators have periodically predicted an exodus from bonds and into stocks, and as in previous years the topic has divided bankers and analysts. BlackRock’s global chief investment strategist prefers equities to fixed income in 2017, and his counterpart at Bank of America Merrill Lynch (BAML) has written that the ongoing shift will intensify when the Federal Reserve’s monetary policy becomes more hawkish and the economy further improves. Goldman Sachs and Citi analysts have dismissed the theory. 

Sceptics can point to the fact that yields fell and fund flows slightly reversed following Mr Trump’s first press conference on January 11, in which he failed to provide any substantive detail on how he will implement his pro-growth agenda. But even before this press conference, and despite the Federal Reserve lifting rates by 25 basis points (bps) in December and signalling two to three hikes in 2017, the ‘no’ camp had some convincing arguments.

“Investors don’t all behave in the same way,” says Demetrio Salorio, global head of debt capital markets (DCM) at Société Générale Corporate & Investment Banking (SGCIB). “There are many different mandates and strategies, so simply changing the direction of interest rates won’t mean that all investors go in one direction or the other. It’s a far more complex dynamic than that.”

Assuming a mass rotation out of fixed income and into equities oversimplifies the investor universe and fails to recognise that equity and fixed-income markets move independently. There is no perfect trade-off between the two asset classes. But new US monetary policy and the expectation of fiscal stimulus does spell big changes for issuer and investor appetite for DCM and equity capital markets (ECM).

The party goes on

DCM bankers are quick to dispute the theory that rising rates are bad for bond markets by distinguishing between investor types. Short-term investors who bought a bond at par which, due to rising yields, is now trading at 90 cents on the dollar will obviously suffer because returns will be negative in the short term. But a buy-and-hold investor who bought the same bond with the intention of holding it to maturity, as it matches its liabilities, may be less concerned about its market price.

For new issuance, bankers are not expecting any lack of buy-side appetite. Long-term investors such as insurers and pension funds have strict mandates regarding the amount they can invest in different asset classes, meaning they are unable to switch from bonds to stocks without prior approval. As such, the flows out of investment-grade bond funds are predominantly retail, which make up a small proportion of the buy-side community.

“They represent about 10% of total investment-grade demand so we aren’t too concerned about that,” says Travis Barnes, co-head of global DCM at Barclays. “Insurance represents about 40%, and we actually expect a boost in their buying because as rates increase they actually prefer to be long-dated and in fixed income. So for those types of corporate credits, I think there will be a lot of demand for it.”

Key differentiators

Credit Suisse global head of DCM Tommy Mercein agrees that insurance and pension funds will be lured to the intermediate and long end of the market by higher coupons, but he also expects retail to continue to reassess their bond holdings. “I think [retail investors] will look at the year-end [2016] performance of their fixed-income holdings and be surprised at the losses, so they’ll rotate out of those and into equities,” he says.

While short-term investors may be less active given that prices are on the slide, this will be offset by the long term being more active. “We are not concerned at all about whether there will be enough demand [this] year to buy new fixed-income securities,” says Mr Salorio. “On the contrary, a whole new category of investors who haven’t been very active, as rates were so low, will now re-emerge and head into new transactions.”

There are also credit investors who run no directional risk on bonds at all, and whose strategy is not affected by rate changes. These investors, predominantly hedge funds, use swaps and futures to hedge the risk of interest rates rising and falling. Their returns are based solely on whether the spread between their bonds and treasuries widens or tightens.

In addition to investor type, it is necessary to distinguish between bond type. High-yield is less sensitive to interest rate risk than investment grade and delivers equity-like returns. It was initially swept up in the move out of fixed income but AJ Murphy, BAML head of global capital markets, says that has since corrected.

“At first I think investors reacted negatively to the rate move discussion coming back into focus so quickly, among all of the other developments that no one had been set up for post-election,” she says. “But in the weeks after we saw funds flow back into high-yield as part of the broader move to risk assets.” Ms Murphy views this as a positive signal for the asset class in 2017.

DCM issuance drivers

After 2016’s record issuance of bonds globally ($6600bn) and US investment grade ($1137bn), and with US rates tipped to rise by 50bps to 75bps, DCM bankers have reconciled themselves to a 5% to 10% dip in primary issuance this year. Today’s 10-year treasury yield, the pricing benchmark for private sector issuers, seems high compared with the all-time low of 1.32% seen in July 2016 following the UK’s Brexit referendum. But historically, sub-2.5% is relatively low.

“Going forward we expect to be in the 2.5% range for 10-year US treasuries,” says Mr Barnes. “Against that backdrop, debt financing still looks pretty compelling for a lot of different use of proceeds.”

Mergers and acquisitions (M&A) have become a major driver of DCM in recent years, and the trend is set to continue in 2017. As at last December, the visible pipeline for M&A-related bond issuance was a respectable $150bn, but it could increase over the first months of the year. Ms Murphy does not expect the policy rate increases to significantly dampen M&A-driven bond supply.

“The types of rate changes we are likely talking about wouldn’t meaningfully change how acquisitions are financed, though financing may become more expensive,” she says. “Investors will still be eager and accommodative of good deals.” The buy side likes M&A-related deals because they have a clear growth story and the proceeds have a tangible use. This is why jumbo acquisition financings are often oversubscribed, and why they are not expected to disappear this year.

“Most investors prefer to be in large, liquid benchmarks rather than a $250m, 10-year bond,” says Mr Barnes. “It’s partly perception, but also some of the larger deals have outperformed. With event financings, the buy side knows the bridge takeout is coming at some point so they can prepare for it.” 

Higher interest rates could, however, diminish the pace of bond refinancings. Another headwind is Mr Trump’s plan to offer US companies a one-off 10% tax holiday on the $2600bn of untaxed earnings they hold overseas. If this materialises, many companies will have less need to raise cash. 

ECM: the other rotation

Among ECM bankers, the mood is clearly upbeat. With the exception of trade protectionism, the promises made by the new US government are pro-business and pro-growth, which investors can benefit from by buying equity. Whether these policies will reach fruition is not yet known, but in ECM investor sentiment can be a self-fulfilling prophecy. If the buy side expects the market to trend up and invests accordingly, it will.

However, ECM was showing positive signs even before the US election. Throughout 2016, secondary markets were liquid, earnings revisions and the S&P 500 had both edged higher, and banks were receiving more queries about initial public offerings (IPO).

“Discussions with companies interested in going public increased during the fourth quarter,” says Douglas Adams, co-head of ECM for the Americas at Citi. “The greatest increase in dialogue [was] in the growth-driven sectors: tech, healthcare, and consumer and retail,” he says, adding that energy should pick up as commodity prices stabilise.

Some ECM bankers even say the rotation from bonds to equities is old news. For as long as central banks have pursued unconventional monetary policy, they have watched investors ditch negative-yielding bonds for so-called ‘bond proxies’, stocks that pay a small, yet reliable, dividend.

The rotation they are more excited about is the one happening in equities. Since the election investors have switched from bond proxies, also known as defensive stocks, into stocks with the biggest growth potential. “We are moving from a paradigm of deflation, low growth, low interest rates and flat yield curve towards expectations of Keynesian economics. That means a rotation out of consumer staples, REITs [real-estate investment trusts] and other defensives and into mining, banks and cyclicals,” says Craig Coben, head of global ECM at BAML.

It is a trend he expects to continue in 2017. Other defensive stocks are utilities, healthcare and telecommunications, while industrials, chemicals, auto, insurance and any company that makes money from the spread on lending are generally regarded as cyclical. Put differently, investors are prioritising long-term growth over short-term dividends.

Reversing the IPO decline

Pro-growth policies and investor appetite are expected to provide a much-needed boost to the IPO market. US listings in 2016 ($24,225bn according to Dealogic) were the lowest in a decade and accounted for about 10% of overall US ECM issuance, with follow-on offerings making up the remainder. In 2017 bankers expect new listings to account for 25% to 35% of dealflow, suggesting multiple reasons why.

IPOs are typically small- to mid-cap companies which are generally subject to the full marginal tax rate, meaning they stand to benefit greatly from the new US government’s plan to lower corporate tax from 35% to 15%. As IPO valuations are based on the present value of future cashflow, their valuations should rise significantly, encouraging them to go public.

Now that investors are willing to look beyond short-term returns, listing candidates also stand a greater chance of their businesses being assessed on merit. “Dividend yield used to be the third or fourth valuation metric to be used in a listing process, but in the recent past it's become the second and sometimes even the first one investors want to look at for benchmarking purposes,” explains Sam Losada, co-head of Europe, the Middle East and Africa ECM at BAML. “For a variety of sectors, rising interest rates will ultimately force investors to look at the fundamental value of a business through the cycle, rather than just assessing it through a yield lens.”

But while valuations are expected to rise, they will stay in synch with earnings. There is no concern about a stock market bubble. “I think we are in a decent place where hopefully sellers think they can get appropriate values for their companies, and buyers think there is still room to run,” says David Hermer, Credit Suisse global head of ECM.

The S&P 500 volatility index is at a two-year low, which will encourage listings, and hedge funds have become more supportive of new deals. “Often, [they] are the first to give you an investment decision, which tends to build momentum. So if you don’t get them in at the beginning of the deal, it can become more of a marketing exercise,” says Clayton Hale, co-head of Americas ECM at Citi. After retreating in mid-2016, Mr Hale says they became more aggressive in the latter half of the year and it is hoped they will remain so in 2017.

Riding the US’s coattails

To the extent that there is a rotation between or within asset classes, it is fuelled by US developments: the new government, improving growth and rising rates. But it is not a purely domestic phenomenon.

“There’s been a knock-on effect in Europe but it’s obviously not as strong as in the US,” says Luis Vaz Pinto, SGCIB global head of ECM. “The cross-border links that have caused this are complicated: some stocks are up because their comparables in the US are up, and some of the European corporates that have rebounded have US operations, so [they are] exposed to the favourable dynamics.”

The consensus is that European economies are not yet ready to turn around as they have in the US. “Europe is clearly behind in the cycle and will continue to see quantitative easing for longer, whereas the US is starting to see a different trend,” says Mr Vaz Pinto. However, other experts point to limits in how far US/EU central bank policy can diverge. Ten-year UK gilt and German bund yields rose after the US election and rate hike, but they lag far behind US treasuries.

“The gap between bund and US treasury yields is back to levels not seen since the mid-1990s and there’s a limit as to how far that gap can become,” says Armin Peter, global head of debt syndicate at UBS. “Some would say we are at the limit now, so the question is if a correction is due and where the adjustment might come from.” History suggests US yields will not keep rising without at least a small increase in European yields.

Those longing for a great rotation – whether in the US or globally – may once again be disappointed. But if the alternative is more normalised bond yields and buoyant IPO market, then perhaps it is better that the shift remains as elusive as ever.