Predictions that an end to US quantitative easing would cause a major upset in the bond markets have not materialised, but the landscape is changing gradually for primary issuance.
The US Federal Reserve’s decision to postpone any tapering of its monthly bond purchases in September 2013 merely delayed the longer term trend that investors consider inevitable. US yields have been at record lows for an extended period, and will surely move higher as the economy recovers.
“US Treasury 10-year yields already widened from 1.6% in May to about 3% by the start of October, so one could say that we are already in something of a bear market for bonds. But no trend is ever linear, and there were even bursts of treasury yield widening when rounds of QE [quantitative easing] were announced, because investors moved into riskier assets. Scaling back QE could see some of the market flow back from equities into bonds,” says Stuart Edwards, global bond fund manager at £73bn ($118.4bn) asset manager Invesco Perpetual.
On the one hand, long-term yields are still very low so it is a good time to lock in and fund these activities, but on the other hand many decision-makers are still uncertain about growth opportunities
Richard Bartlett
Expectations of higher yields have coincided with regulatory pressure on investment bank balance sheets, for which fixed income carries high capital requirements. Consequently, secondary market trading volumes are thin. But this has done little to stem the ability of issuers to tap the primary markets.
“The market backdrop is strong, with plenty of investor demand for new paper and corporate issuance light by historic standards because companies have high cash balances and are making limited investment activity. Despite bank deleveraging, both banks and fixed-income funds are underlent and willing to offer aggressive terms on deals,” says Richard Bartlett, head of debt capital markets (DCM) and corporate risk solutions at RBS.
Strategic shift
However, potential issuers and investors are thinking about how an eventual rise in rates affects their strategy. Mr Edwards says conditions favour investors with flexible active mandates, who can shorten duration in their portfolio and seize tactical opportunities as bond prices become more volatile. In the first instance, he expects higher yielding corporates to outperform investment grade, as spreads on investment-grade bonds are so tight they are likely to rise in tandem with rates.
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“Ultimately, one would expect high-yield issues to begin to suffer if there is an expectation of falling credit quality because of the impact of rising rates on corporates that leveraged up. But that phase will need an expectation of actual rate hikes, not just tapering of QE, and we are not at that stage yet,” he says.
As for issuers, Christopher Marks, global head of DCM at BNP Paribas, says that the extended period of low rates has allowed corporates to pre-fund regular redemptions, reducing future issuance needs. He sees the market favouring corporate issuance, since high-grade sovereigns and agencies are the focus of concerns over the end of tapering, while banks are still subject to uncertainties over regulatory developments and the European Central Bank’s asset quality review.
“The question now is whether companies will start taking the big decisions on capital expenditure and mergers and acquisitions. On the one hand, long-term yields are still very low so it is a good time to lock in and fund these activities, but on the other hand many decision-makers are still uncertain about growth opportunities,” says Mr Marks.
New opportunities
Although eurozone growth is far from strong, there are signs of improvement even in the periphery, and non-European investor fears over the future of the euro have given way to opportunistic investment. Mr Bartlett says one of the prominent trends in recent months has been the advent of alternative credit funds ready to pick up yield by buying into loans, private placements or structured finance. The traditional credit players – mostly US insurers – have been supplemented by new investors, including Asian and sovereign wealth funds.
“These funds have long-term investment horizons and are flexible on the types of assets they will buy. That has allowed structures such as securitisations of existing loan portfolios to recycle balance sheet, but the main challenge has actually been a shortage of potential issuers because banks in general are cutting their wholesale funding needs,” says Mr Bartlett.
At the moment, demand is still outstripping supply in the bond markets, so that bank deleveraging has not caused capital constraints for larger corporates. But Mr Bartlett says the real test of capacity will come when corporates begin to releverage their balance sheets once growth prospects look more secure. Their demand for credit will then rise, but the regulatory constraints on banks will remain, so new lending may eventually stretch bank capacity pushing more borrowers into the bond markets.
