Sentiment Split in US Bond Market
At any other time, record issuance and record outflows in US investment grade would each be worthy of attention. Given the havoc COVID-19 has wreaked in recent weeks, it would be tempting to write off these milestones occurring in parallel last week as merely the latest quirk of an unprecedented period for bond markets, but the reasons behind this apparent sentiment split are worth keeping an eye on.
Bond market balance has certainly improved in recent sessions, driven in no small part by a $2tr stimulus package from the US government and the promise of unlimited liquidity from the Federal Reserve, along with the launch of the central bank’s first ever corporate bond purchase programmes.
In this context, it was no surprise to see investors take down $110bn from 43 issuers in the five business days to March 25, a weekly record for US IG issuance. Month-to-date volumes of $210bn and year-to-date volumes of around $440bn are now also running at record pace.
The improved sentiment didn’t seem to fully penetrate the secondary market, where despite new issues largely performing strongly, a record $43bn flowed out of IG over the same period. This was the third consecutive week of domestic outflows for US IG, and can be explained by a number of factors including the continuation of forced selling, either through redemptions, margin calls or the need for cash.
The influx of new issues paints a different picture, and we see a number of important factors behind the surge of supply.
Firstly, there is disruption in the commercial paper (CP) market, which has been under considerable strain as investors have become reluctant buyers, meaning rates on longer term CP have increased significantly and many firms have been unable to issue with terms longer than a week. The Fed has sought to address this issue with its new Commercial Paper Funding Facility (CPFF), a support mechanism for A1/P1 issuers established using the Exchange Stabilization Fund (ESF). Note, the Fed did not establish a maximum size for the facility, and it should encourage investors to once again engage in term lending in the CP market. However, crucially this facility will only become operational in the first half of April, which has driven many companies to seek longer term funding in the bond market. It is evident from the duration and credit quality of this month’s supply that the primary market has been dominated by traditional CP issuers.
Secondly, these high quality borrowers look to have paid healthy premiums to issue debt this month, and printed at secondary spreads not seen since the financial crisis. These more attractive terms for investors have led to strong demand for bonds, with deals said to be heavily oversubscribed and also enjoying very strong performance in the secondary market. Examples would include bonds from Proctor and Gamble (Aa3/AA-), General Dynamics A2/A), Lowes (Baa1/BBB+) and Coca Cola (A1/A+), where spreads have narrowed anywhere between 85bp and 105bp from the initial issue price.
Third, for those with cash to invest, the primary market has proven to be a good outlet to obtain liquidity. Investors wishing to add credit will have been frustrated by the lack of liquidity in secondary markets, which will have focused them on new supply to obtain bigger size, especially given the resurgence of new issue premiums.
Finally, the record outflows and difficult liquidity conditions we are experiencing in the domestic secondary market would suggest we are seeing increased interest from foreign buyers. As such, we would expect demand for US investment grade credit to remain fairly supportive, as dollar IG yields continue to look historically attractive for Asian investors (as well as domestic investors for that matter).
This is a story worth following, particularly since April tends to see issuance subside due to issuer earnings blackouts. As the CP market begins to enjoy the support of the Fed’s CPFF facility, high quality borrowers should see short term funding pressures abate, meaning the primary market supply investment grade investors enjoyed last week may also die down.