A stimulus-fueled debt issuance binge is showing signs of faltering as the largest and best rated companies in the world find themselves in unfamiliar territory – a “new normal” where liquidity is at a premium and terms are being dictated by an investor base that finds holding cash more lucrative than investing in debt.
A spike in inflation - driven partly by generous monetary stimulus packages during the COVID crisis, and the disruption of the global supply chain due to the ongoing Russian invasion of Ukraine - has the Fed making a massive U-turn from a decade-long practice of pumping liquidity into the financial markets.
This has led to global market volatility and hindered debt issuance in the US high-grade bond debt market which serves as the liquidity provider to the largest multinational companies in the world.
2020 and 2021 saw a massive debt issuance binge by companies who raised over $3.3trln in the US debt market to, not only survive the COVID crisis, but to subsequently take advantage of flush liquidity conditions.
“The Fed is pulling back. . .we can all debate whether they mishandled the timing of that pivot, but the fact remains that the Fed is now draining liquidity out of the market and that is negative for all risk assets including spread product like investment grade,” said Maureen O’Connor, Global Head of High-Grade Syndicate at Wells Fargo during Informa Global Markets’ latest IGM Credit Corner Vlog.
“Investment grade total return losses are now down around 13%, year-to-date. It rivals the worst 4- month period for the asset class in modern history, on par with the losses we saw during the height of the financial crisis in late 2008 - which is almost mind boggling to think about.”
One major differentiating factor between 2008 and now is that the former was driven by a deterioration in credit fundamentals while this current phase of poor returns is due to technical factors – basically, the repricing of assets to reflect prolonged inflationary pressures and the Fed’s forced push of the direction of interest rates.
“If you peel back the onion on returns, you can see that, yes, we're (investment-grade returns) down 13+ percent, but excess returns or spread driven returns are only down about 3%. So, it’s the move higher in Treasury yields, which is obviously highly correlated to what the Fed is doing to tame inflation, that is driving the majority of the total return losses we have seen thus far,” said O’Connor.
“I think we can probably all argue that at this time last year, when the US investment grade bond index was trading at its cyclical tight of around 80bps, that was artificially tight. That was driven by the positive technicals prevailing at that time. So, the spread widening we have seen since the late November pivot is simply the market coming down off that sugar-high of accommodative central bank policy globally,” she added.
The average high-grade bond spreads were quoted at 147bp over Treasuries as of May 13, according to ICE BAML data, or near the highest 152bp level (midMarch) this year after meandering in the 86-100bp range in the whole of 2021.
The change in market dynamics has caused money to move out of funds dedicated to investing in high-grade bonds. Outflows from US high-grade funds and ETFs totaled $6.75bn the week ending on May 11 adding to a $8.16bn outflow from a week earlier.
And as liquidity becomes scarce, the supply of new bond offerings in the US high-grade primary market – the recipient of Fed liquidity measures that ensured the survival of large businesses through the COVID crisis - has started to slow.
New issue volume last week totaled just $21.7bln, shy of the average weekly estimate ($32.3bln), for the third straight week, and issuance for May, a month that was expected to produce, on average, $138bln in ex-SSA issuance, is at just $40.11bln. Syndicate bankers were expecting an average $1.38trln of debt issuance this year but that number is now being seen by some as too optimistic.
“We are just trying to find the right equilibrium in a world where the Fed is working against us, not for us. Our biggest challenge is certainly advising issuing clients on how best to navigate this increasingly volatile market,” said O’Connor.
“One thing we can say for certain is that the advice to wait for markets to come back to us either with respect to Treasury yields rallying or spreads tightening has not played out well so far this year because new issue premiums have only gone higher and spreads wider,” she added.
With spreads likely to only move wider, O’Connor said issuers are being asked to be nimble around certain pockets of opportunity where they can catch a little bit of what are occasional rallies in asset prices in a largely bear market.
There is also some differentiation between the haves and have-nots but liquidity, though selective, is still sufficiently available for the higher quality names.
“There is a growing propensity for investors to favor larger cap structure, broadly-sponsored credits to the detriment of some of the more off-the-run types of names with challenged secondary market liquidity,” said O’Connor.
That dichotomy was played out on Thursday when A3-A- rated Intercontinental Exchange priced a $8bln 6-pt M&A bond offering ($5bln was allocated for M&A) – the eighth largest deal of the year and the fifth largest FIG deal of 2022 – on total books of $26bln while Baa3/BBB rated Var Energi raised $500m via a 5yr bond, after dropping an intended 7yr and 10yr tranche, on books of only $700m.
“We are still in the early part of the tightening cycle where the weakness in investment grade credit is driven largely by technicals. Credit fundamentals are still strong. I think a lot of investors are looking at circa 3% 10-year Treasury yield and a spread index that is 50bps+ wider than tights this time last year and are viewing this window as an opportunity to layer into investment grade credit.,” said O’Connor.
“We have experienced substantial outflows from high grade funds, which is essentially total return and/or retail money. But there’s just as much institutional cash looking at this as an opportune time to be invested in high-grade. And so long as new issues continue to pay reasonable concessions, these investors are going to preserve what liquidity they have to play in the cheap primary calendar rather than chase secondaries tighter,” she added.
According to IGM calculations, new issue concessions calculated off secondary levels of outstanding and comparable bonds have ticked up to an average 11.17bp last week compared to -1.9bp and - 5.7bp annual averages in the prior two years, respectively.
To view the VLOG, go to: