Corporate bond issuance has been strong over the last two months despite a brief slowdown prior to the French presidential elections. Syndicate desks at investment banks continue to aggressively tighten guidance from the Initial Price Talk (IPT). The level of new issuance tightening is usually a strong guide to market appetite and the attitude to risk. It implies there is still a lot of mileage in investment grade credit.
At the moment syndicate desks are squeezing the new issue premium 15-20bps, bringing new deals at or very close to secondary curves. By pricing at levels near to existing bonds or comparable issues, we are seeing new issue premiums squeezed to 2bps. Earlier in the year the revisions to initial guidance were generally 10-15bps.
The continuation of the ECB’s bond buying programme is providing a strong technical push in Europe; it has now purchased about €90bn of bonds or the equivalent of 90% of net new issue (i.e. new bonds less redemptions). The hunt for yield and income is also continuing to attract strong demand in the US. Even large M&A-led issuance such as the recent Cardinal Healthcare multi-tranche issue tightened (in some tranches) by 30bps pre-launch. Normally these types of deals require some concession from the issuer to ensure that the new large supply of bonds finds a stable home.
But as long as books are reasonably well covered, this indiscriminate cutting by 20bps continues and it makes relative and absolute value analysis of individual deals harder to discriminate between the good, the bad and the ugly. With a number of outstanding M&A transactions yet to be financed, supply until the end of the year is likely to remain strong. As long as the market remains robust this supply will be readily bought; however initial guidance and the subsequent revisions are likely to be tested if demand into investment grade credit starts to slow.
In certain sections of the investment grade market the credit cycle could best be described as “mature”. By that I mean companies are looking for ways to reward their equity holders, rather than bolster their credit rating.
There have been numerous examples in recent months where companies have taken advantage of historically low cost of debt to either finance acquisitions or return money to shareholders. More often than not this has meant a downgrade in the credit quality, and poor relative performance from their existing bonds.
It’s at times like these that credit investors seek out bonds with protection from a strong set of covenants. These are the rules and regulations laid out in the bond documentation that dictate what the issuer of the bond can and cannot do. These can include rules around distributions to shareholders, maintaining a credit rating, and importantly the amount of leverage that the business can run. In an environment where companies are generally adding more financial leverage to their business, these covenants are a valuable safeguard for bondholders.
In the UK credit market, the strongest covenants tend to be found in the fixed rate securitised sector, where companies pledge assets against their debt. We have been investors in this sector for a long time, valuing the protection these covenants afford.
A further benefit from a strong set of covenants is that when companies outgrow their existing debt structure and want to refinance they often have to pay their bondholders a premium to redeem their bonds early. These “make-whole” payments can be significant depending on the maturity of the bonds.
A very recent example of this is Annington Finance; a complex and highly covenanted bond structure secured on a portfolio of Ministry of Defence housing in the UK. We have been invested in its bonds for many years. The company has announced its desire to redeem its entire debt structure, and refinance in a more vanilla manner. Should it proceed, bondholders look set to benefit from material “make-whole” payments. It’s a timely reminder, in a world where credit quality is being sacrificed, of the worth in a well-covenanted bond structure.
We believe there is a long shadow of the 2008 Global Financial Crisis (GFC) that still prejudices investor sentiment to risk and return within corporate bond markets.
Recently we were asked about default rates in investment grade credit, and what impact this had on our positive view of the asset class.
We answered that over time investment grade spreads more than compensate for the risks of generic ownership of investment grade bonds. To support our view we borrowed some long-term evidence from the 2016 S&P ratings analysis around defaults, covering the period from 1981 to 2016.
According to the study, the Lehman default was twice the size of the next largest defaulter – Ford Motor Co., in 2009 – which in turn was almost twice the size of Energy Future Holdings at $47bn in 2010. In each year prior to 2008 (excluding WorldCom in 2002), the total default amount was less than $10bn.
Yet the lingering concern for credit markets continues to be the revisiting of the scale and size of defaults in the GFC – and the knock-on contagion that curtails access to credit. Our brighter view is that there continues to be ready access to credit for investment grade issuers and that the outlook continues to be for solid, sustainable growth – which doesn’t have the same cyclicality as we have seen over the past 40 years (the period of the S&P study).
We would note that the 2008 GFC was the first systemic crisis within the S&P study period, while the next crisis is likely to take a very different format to that of 2008, not least due to the regulatory and macro prudential steps taken by authorities since 2009.
In the last five years, 99.7% of BBB issuers have not defaulted. In terms of the triple digit basis point spreads available in investment grade markets over that period (and today), the defaults have been almost de minimis. So we continue to believe that the ongoing benign economic outlook combined with active management can ensure good levels of capital preservation in well-constructed corporate bond funds.
2016 Annual U.S. Corporate Default Study And Rating Transitions – click here to view
The Bank of England is within sight of the end of its corporate bond purchase scheme, a year ahead of schedule, having bought in excess of £9.1bln worth of bonds since the end of September last year. Given the relatively robust performance of the economy since Brexit, an increase to the £10bln target at this stage is deemed highly unlikely.
Evidence would suggest that the original aims of the programme – reducing the cost of borrowing for companies, encouraging companies to issue more corporate bonds and triggering portfolio rebalancing into riskier assets – have largely been met. Corporate bond supply has increased, spreads are tighter (albeit not uniformly) and lower quality spreads have compressed.
While not an explicit aim, the consistent bid for risk over the past few months has also led to reduced volatility and a marked improvement in liquidity. Going forward, a deterioration in that secondary liquidity following the end of the programme is a concern. As the rate of the Bank’s buying slows, recycling risk becomes more challenging, particularly given relatively tight valuations. Dealer inventories grow and spreads widen. There is evidence this is happening. Sterling credit spreads (libor OAS) are currently c7bps tighter YTD having been as much as 13bps tighter in early March.
The end for sterling corporate QE is not the only factor driving our currently cautious stance towards credit risk. Brexit uncertainty, the potential for Trump disappointment and European political risk also vex. However as a precursor to the potential end of the ECB buying programme next year, it is certainly worth watching.