Credit: strong demand drove record supply, ultimately causing a self-adjustment of the latter
As underlined in our April issue (see “A high-octane primary market blunts euro credit market performance”) the ECB’s QE announcement produced a remarkable rise in both investment flows and supply volumes of EUR corporate bonds. Inflows into funds and ETFs dedicated to high grade and speculative grade corporate bonds rapidly increased in the weeks and months following the January 22 QE announcement: at the same time, volumes of new debt issued in the primary market also jumped. In credit markets, demand usually drives supply more than vice versa and, this time, this was even more apparent, because of the extraordinary features of Draghi’s latest measures. Higher demand for yield and spreads was rapidly matched by stronger supply, which ultimately overcame the flow of investments: the resulting effect, as we pointed out, was an apparent paradox of underperformance suffered by the asset class most supported by yield search forces, right in the very first month of ECB buying. In this respect, if March represented one of the busiest months for both IG and HY primary market activity, April and May were quite different stories: April saw a slowdown of new issuance following what we could define as a sort of “market indigestion”, and then the global re-pricing of government bond markets over the last few days of that month led to even lower levels of supply in May. Accordingly to the change in technicals, performances changed direction as well and excess returns turned to be positive. The point is that technical factors affecting the demand-supply balance look to be quite relevant in this liquidity-driven phase.
Technical factors matter on the sovereign bond market
Long-term bond yields jumped in the developed countries (Germany but also US, UK, Australia, Canada, etc.) at the end of April and in May. Global factors were at work, mostly the rebound of oil prices since mid-March driving the rise of inflation expectations. The rise of long-term yields has been stronger in Germany, probably as profit taking has been significant after five quarters of yields’ decline. Technical factors have probably also played a role as May is traditionally the month where net issuance of govies is by far the strongest of the year for the Eurozone taken as a whole. Moreover, April 2015 was a month of very negative issuance for core countries, what has probably driven yields to extremely low levels. On May 19, Benoit Coeuré declared in a speech that the ECB would accelerate its sovereign bonds purchases in May and June, in order to slow them in July and August where “the market liquidity is notably lower”. This immediately contained the rise of German yields. He explained that the “slightly higher purchase volume is unrelated to the recent episode of market volatility”: this point is hard to believe as the Eurosystem accelerated only slightly its PSPP purchases over the first weeks of May (by around $2bn/week). This would indicate that Eurosystem’s purchases would be only marginally lower in July and August, at a time when net issuances are usually weak. In other words, technical factors will tend to support the fixed-income markets in the coming weeks.
Demand for more credit and duration risk welcomed by supply
Non-financials still driving issuance…
Over the last few years, banks’ deleveraging and disintermediation has led to quite a divergence in gross and net new issuance of financials and non-financials. As a result, outstanding debt of industrials and utilities now accounts for 60% of overall EUR IG debt, compared to only 45% four years ago and 50% three years ago. The search for yield is and will remain a dominating force in European bond markets: the more yield has concentrated in lower-rated/longer-duration curve segments, the more High Grade corporate bond markets have adapted to higher demand for combined credit and duration risk. Profiting from the low yield environment, companies locked in very low funding costs for a prolonged period, lengthening the average duration of their liabilities through the primary market. Note that on the sovereign side, some countries (mainly Germany, Spain, Belgium, Netherlands, Portugal) took also advantage of the low yield environment in the recent months to lengthen the maturity of their bond debt.
…Mainly through long-duration/low-rated bonds…
The first of the reported graphs shows the recent dramatic trend in IG non-financial new issuance by maturity segments. In first four months of 2015, a remarkable 45% of new bonds were issued with maturities of 10 years or longer; only 33% and 29% of bonds issued over the same period in 2014 and 2013, respectively, had maturities this long. The 7-10 year segment saw an increase, too, from 19% and 20% respectively in the first four months of 2013 and 2014, to 24% this year. The second graph shows that low-rated issuers drove most of the recent debt growth, rising from a quarter to a third of overall IG non-financial issuance volumes. Since the ECB “pre-announced” its upcoming QE last September, out of €100 billion in overall net issuance, €73 billion belonged to BBB-rated names, a dominant proportion of new debt placed among investors.
…With a greater role of US companies
Non-European issuers and in particular US companies, attracted by very low financing costs with respect to their domestic market, have played and continue to play quite a role in this process. While American companies accounted for just 5% of overall EUR denominated non-financial debt two years ago, they currently make up 12% of the total, meaning that the US is the third most represented country, after France and Germany.
The result: a “new” universe of IG corporate bonds incorporating more combined credit and duration risks
As a result, average duration of the EUR IG corporate bond universe rose sharply in recent years after the previous fall, which was mainly caused by the GFC and the sovereign debt crisis. As the reported chart shows, the average duration of industrial bonds increased from 4 years to the current 5.6 years in just three years, with most of the move made over the last eighteen months. Financials and utilities also turned to issue longer maturities, but to a much lesser extent than industrial corporates. As a reported graph also shows, the corresponding increase in duration of speculative grade has, as a result, been much more subdued. HY bonds saw their average duration increase by just over half a year while, over the same period, IG duration increased by more than eighteen months. Lower quality and higher duration mean a more risky profile for IG corporates in terms of total return performance and investment flows when a reverse scenario takes place on yields. At the same time, the recent trend in the EUR corporate bond market makes its universe more “complete” and closer to the US one, offering more opportunities in the longer segments of the yield curves where the search for yield forces are most felt in the current phase.
Let’s consider net supply, too: year-to-date vs. 2014
As we already underlined, QE spurred a record issuance of gross supply over the first four months of 2015: non-financial companies, namely industrials and utilities, have already issued half of their overall 2014 gross issuance. Financials still lag these numbers, despite a strong start by covered bond issuance, as one of the asset classes within the ECB’s buying scope. Still, it’s the trend in net supply where the results are more shocking: net debt, namely gross issuance minus bonds matured, issued by non-financials in Jan.-April 2015 is at the same level as the volumes issued for the whole of 2014! On the contrary, financials were still negative, despite regulatory reforms and covered bond activity: gross issuance was very close to €100 bn, lower than the €125 bn in maturing volume, with a consequent negative net issuance in the range of €25 bn.
Therefore, what should we expect in the immediate future?
Given the unprecedented primary market activity and positive net issuance delivered so far, the coming months are likely to see a slowdown in supply: among the major factors pointing to this outcome are the slowdown in investment flows, the significant frontloading in funding attained by many issuers, the recovery of bank loan volumes with more competitive terms than the bond market. The recent re-pricing of government bond yields affected IG total return more than HY total return and has already led to a slowdown in investment volumes flowing into high grade corporates. As pre-funding and front loading of issuance are well underway for many issuers, it is reasonable to expect a more supportive demand/supply balance over the coming months and this should support the technical forces in favour of corporate bonds.