Fixed Income Quarterly—Outlook
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bonds by any means possible, after witnessing external demand siphon significant corporate product from the market.
Managing a corporate bond fund generally entails buying corporate bonds, not money market instruments. Whether investors like it or not, the hard reality of the situation dictates that there is intensifying competition for corporate bonds. A multitude of investors need product: investable product that generates decent returns. In the competition for corporate bonds, some investors are willing to concede a few basis points in order to get the product. And that is where we are at right now. It should be to no one’s surprise or consternation that issuers are taking advantage.
What to Do, What to Do?
First and foremost in the current environment, we advise investors to improve credit quality when possible. That is not to say we are suggesting investors avoid higher-beta sectors; quite the contrary, we currently have both REITs and Tele- com rated Outperform. Within sectors, however, we believe investors should focus on their preferred issuers and look for opportunities where they can pick up bonds from those enti- ties by trading out of issuers perceived to be less desirable. Of course, this strategy is almost of the “no-brainer” ilk, but with many investors indiscriminately throwing cash at corporates and spreads at multi-year lows, the opportunity to upgrade is something that should be pursued. Similarly, trades that re- duce duration at flat or modest gives in spread, or that reduce duration and improve quality should be considered. Again, the above suggestions are not the most sophisticated, but rather ideas that we believe are being overlooked in the race to add bonds, any bonds.
We also observe that investors with the internal capacity to do so are adding U.S. bonds from cross-border issuers, sometimes on less favourable pricing just to add product in the size needed. Unfortunately, this option is not available to most investors, who are mandated to own Canadian bonds.
Interestingly, we are now seeing investors buy secondary bonds ahead of new issues since many primary market transactions are being priced with negative concessions. Oh how times have changed when anticipating new issues means buying bonds instead of selling; however, with negative concessions re-pricing entire curves and spreads narrowing further on the break, such a strategy has proved to be beneficial. The fact we are seeing negative concessions is profoundly indicative
of the market distorting capabilities of the current demand/ supply disequilibrium.
Has New Issuance Turned a Corner to the Upside?
It remains to be seen whether monthly new issuance volumes around the $8–9 billion level will continue into April and be- yond. At this point, we are highly sceptical. There is very little in the pipeline on the road show calendar, and many investors have resigned themselves to expectations for a strong second half of the year. Furthermore, the volume of deals from non- financials so far in 2014, at almost $11 billion, is $3.3 billion ahead of last year’s level, suggesting primary market activity for those sectors is running at full tilt, with little more upside possible.
At the same time, issuance from the financial sectors is down quite substantially from year-ago levels. Since a host of is- suers from these sectors can easily come to market with a $500 million to $1+ billion deal, we believe the ability of the primary market in Canada to overcome a slow start to 2014 is meaningfully mitigated. Nevertheless, much of this deci- sion making will be based on factors beyond the control of Canadian investors, such as swap spreads, or foreign demand for bonds from domestic financial issuers.
For full-year 2014, we reiterate our expectation of issuance between $90 billion and $95 billion.
Investors Getting Higher – Quality and Beta
Along with the indiscriminate buying noted above, it has been difficult to discern any sector trends in buying from a spread perspective. On a year-to-date basis, there has been mate- rial tightening for both high quality (e.g., Banks, Pipelines, Infrastructure) and high beta (e.g., Oil and Gas, Industrials). However, of the several sectors that have really knocked per- formance out of the park, all are from the high beta arena Real Estate, Retail and Telecom. What’s more, these three sectors have also experienced material bull flattening, indicating inves- tors, just like last year, are adding risk in terms of both credit and duration. Overall, the 2s-30s credit curve has flattened by about 6 bps so far this year, with spread narrowing by roughly 7–9 bps in the short end, 9 bps in mids and 13 bps in longs. Much like last year, demand for corporates is across all sectors and segments of the curve.