Authored by BofAML’s Hans Mikkelsen,
Fear the bear flattening
What if this was the year where the Treasury curve bear flattened completely as happened in 1994? While this is not what we are looking for, we have highlighted this outcome as the biggest and most relevant risk to credit this year, and with a probability that we believe appears uncomfortably high. While the total return performance of the high grade market in a Treasury complete flattening scenario would be extremely adverse (losses of at least 10%), the pension “reverse rotation” story that we subscribe to serves to significantly limit losses for excess return investors to just 80bps, as the long end of the spread curve outperforms.
Still, as the majority of high grade investors nowadays have total return – as opposed to excess return – objectives (Figure 8), a complete bear flattening of the Treasury curve would be quite devastating.
To show the potential impact on credit returns we run three scenarios as described in Figure 11.
First our “Baseline” scenario is simply the most likely outcome this year for reference – i.e. higher interest rates and tighter credit spreads, without the big flattening move. As shown in Figure 9 we expect total returns of -105bps under this baseline scenario between now and year-end and, as highlighted in Figure 10, excess returns of +198bps. Furthermore total returns should be positive in the front end, while excess returns are especially attractive toward the back end.
In the “Treasury flattening” scenario (see Figure 11 for the details) we show the impact of a complete bear flattening Treasury curve to 5% yields at all maturities, while credit spreads tighten as in the baseline scenario. Clearly the impact on total returns (Figure 9) is devastating, as our index stands to lose 10%, led by the long end (-14%) – but even the front end 3-5-year maturity bucket stands to lose 9%.
Finally we show a more realistic “Flattening, widening” scenario where the bear flattening of the Treasury curve leads to a rotation out of credit and much wider credit spreads (Figure 11). Obviously this scenario compounds the total return losses in Figure 9. However, we assume that the 50bps spread widening from current levels is led by the front end and 10-year sectors, as the pension/insurance bid for long paper keeps the back end in check. Thus excess returns under this scenario in Figure 10 range from -210bps in the 7-10-year sector to just -3bps and -8bps in the 1-3-year and 15+-year maturity buckets, respectively.
The bottom line is a more dramatic bear flattening in the Treasury curve has very significant implications for credit spreads and pension fund returns (and allocations) all of which are negative for stocks – no matter what your friendly local asset-getherer tries to tell you about Forward P/Es or higher rates mean strong economy… you can’t fund buybacks or dvivdends at anything but shareholder-wealth-destroying levels once rates and spreads start to rise… and if spreads are rising then SMEs are not going to be getting the credit that everyone assumes will fuel the next leg of Capex (or whatever dream there is)…