The big issue (Archived)
Standish’s1 Raman Srivastava and Newton’s Khuram Sharih consider how increased issuance in 2016 will impact bond market volatility and appeal.
The coming year promises to be a challenging one for fixed income. On the one hand, the search for yield in a low interest rate environment seems likely to continue to push investors towards riskier assets. At the same time, a slowdown in China and fears around the strength of emerging market growth could increase pricing pressure on high yield debt. Meanwhile, the question of interest rates remains front and centre. It all adds up to a mixed outlook for debt issuance in 2016 says Standish managing director of global fixed income and co-chief investment officer Raman Srivastava – with the prospect of vastly differing levels of support for new debt issuance depending on geography, quality and maturity.
One key factor governing investor appetite in 2016, says Srivastava, is the ongoing overhang of US investment grade corporate debt after a bumper year of issuance in 2015. According to Standish figures, US primary investment grade bonds worth more than US$1 trillion came to the market by the third quarter of 2015, a 57% year-on-year increase in domestic non-financial issuance.2
Srivastava says investors are well aware of this debt overhang – and that pricing will be affected as a result. “In itself it won’t necessarily mean a continued selloff,” he says. “Nonetheless, it will make it difficult for the market to significantly tighten with this headwind of supply.”
An M&A boom has been partly to blame. Ten of the top-20 largest deals of all time occurred in 2015, translating into a 334% year-on-year increase in acquisition-related financing by the third quarter, according to Standish (see Figure 1).3 The trend is likely to continue through 2016, says Srivastava, pointing to a healthy M&A calendar in the telecoms, energy and financial services sectors.
Corporate buybacks have also played their part, with companies issuing debt to buy up their own shares. Srivastava is less bullish on further issuance of this type because, in many cases, companies’ leverage has hit unsustainable levels. This is particularly the case in the oil and gas sector, he says, where a fall in the oil price has driven down revenues and profitability and so pushed up debt ratios – thus making it difficult for companies to secure further debt funding.
Interest rates still key
For Newton fixed income portfolio manager Khuram Sharih another factor affecting debt issuance in 2016 is the perennial question of interest rates. He notes a “decent pipeline” of companies looking to raise capital, but says they are likely to try to time any forays into the markets with the US Federal Reserve’s pronouncements and with periods of a strong technical rally, making for a choppy issuance schedule.
“As we get closer to any rates decision or policy meeting, bond issuance tends to become more erratic as companies try to assess the interest rate environment going forward,” he says. “Previously we’ve seen an increase in the supply of new bonds coming to the market subsequent to dovish comments from policymakers. We don’t foresee this kind of sensitivity to interest rates coming to end over the next several months.”
Srivastava agrees that interest rate moves will be key in 2016 but argues the “lower-for-longer” paradigm has lessened anxiety about higher rates. In support of this view, he highlights a 22% increase in fixed-rate supply to the third quarter of 2015 year-on-year, compared with a 38% decline in floating-rate note volume over the same time period in 2014.
“There was concern over interest rates in the second and third quarter of 2015 as we headed into what was meant to be a tightening period but there is less concern now,” he says. “Even with a hike, the expectation is for limited and not aggressive rises. In that sense floating rate coupons don’t look as attractive as they once did.”
High yields, rising defaults?
Turning to the high yield space, Sharih highlights the prospect of rising defaults. Data from credit ratings agency Standard & Poor’s showed a 2.5% default rate through the first three quarters of 2015 – well below the 1971-2014 long-term weighted average of 3.49%.4 But this belies the underlying weakness in energy and mining companies which have been under extreme pressure due to the decline in commodity prices as global growth stalls.With commodities companies making up over 20% of the global high-yield index, he says, this will have a knock-on effect for new issuance and pricing: “As we see volatility pick up there’s the risk of contagion spreading to other parts of the high yield space along with increased default risk. There are many sectors, such as manufacturing and industrial equipment, indirectly exposed to the slowdown in demand for commodities and falling emerging market growth.”
As a result, he says, investors are likely to become more sensitive to fundamentals and news flow around high yield fixed income in 2016. That could translate into opportunities in bonds that have been oversold – but it will also diminish investor appetite for companies trying to issue debt.
Srivastava expects a similar trend in emerging markets, highlighting Standish’s expectation of no real pick-up for 2016 from 2015’s estimated supply of high yield debt of US$251bn. “Generally speaking,” he says, “emerging market corporates seem to be less inclined to tap the hard currency market given the prospects of higher US rates and a stronger US dollar.”
On the question of sovereign debt, Srivastava says the focus on deficit reduction led to low sovereign issuance in Europe in 2015. At the same time, the European Central Bank’s (ECB) quantitative easing (QE) programme was a source of demand and put additional pressure on new supply. As a result, pricing has been stable, he says – and could yet pick up should the ECB decide to expand its QE programme further. This means there should be a supportive pricing environment for new issuance in 2016, he says, especially since Standish expects net issuance of around €190bn, down €26bn from last year.
In treasuries, the story is less about issuance and more about the abundance of supply coming from China as it sells down its US dollar reserves. For Srivastava, the real question is at what pace that sell-down continues through the first half of 2016. He notes that for many years there has been a premium on Treasuries as emerging markets built up their foreign currency reserves. “But we’re definitely now in the part of the cycle where that is beginning to reverse,” he concludes.
What to watch
- More mega M&A could ramp up the need for acquisition finance; exacerbating the current overhang of investment-grade credit.
- Defaults in the basic materials, oil and energy sectors could undermine demand for high yield bonds.
- Pulling the QE trigger: Additional quantitative easing from Europe could increase support for euro-denominated sovereign debt issuance.
1.BNY Mellon Investment Management EMEA Limited is the distributor of the capabilities of its investment managers in Europe, Middle East, Africa and Latin America. Investment managers are appointed by BNY Mellon Investment Management EMEA Limited or affiliated fund operating companies to undertake portfolio management services in respect of the products and services provided by BNY Mellon Investment Management EMEA Limited or the fund operating companies. These products and services are governed by bilateral contracts entered into by BNY Mellon Investment Management EMEA Limited and its clients or by the Prospectus and associated documents related to the funds.
2.Standish estimates as at 20 October 2015
3.Standish estimates as at 20 October 2015
4.Standard & Poor’s, ‘defaults on a trailing 12-month basis’, 20 September 2015.