Barring an external shock that sends global risk assets lower, the Federal Reserve’s (Fed) decision to keep interest rates unchanged while lowering its projected pace of future rate hikes is likely to support a continuation of the heavy pace of new corporate bond issuance and merger and acquisition (M&A) activity in the US investment grade (IG) market. The move lower in the US Treasury yield curve after the Federal Open Market Committee (FOMC) decision will likely help keep borrowing costs associated with corporate bonds low, so this source of financing should remain attractive to issuers, in our view. As a result, Invesco Fixed Income expects the pipeline of M&A-related corporate bond issuance to continue.
Improving demand
While a heavy pace of new issuance had weighed on US IG credit spreads over the prior 12-month period, we’ve recently seen signs of improved demand for the asset class. Despite more than $50 billion of issuance from a multitude of issuers over the three-day period following Labor Day, the market appeared to absorb the heavy supply very well.1 Most deals were significantly oversubscribed, which means they attracted orders from investors well in excess of the amount of bonds companies were looking to sell. As a result, most deals priced with meaningful, yet smaller, concessions compared with bonds issued during the summer — yet they still performed well after opening for trading.
Attractive valuations and stabilizing global risk sentiment appear to be driving improved demand for corporate bonds. The Barclays US Investment Grade Credit Index has recently reached its highest yields and widest spread levels compared with the past three years, as the graph shows. As a result, we expect demand for new issues post-FOMC meeting to remain strong.
Highest yields and widest spread levels since 2012 have spurred increased demand
Compelling risk-reward proposition
While we recognize the risk that another extended period of above-average issuance growth could eventually weigh on the market once again, we believe that current valuations make the risk-reward proposition for the asset class more compelling. Three of our preferred investment strategies include:
- Seeking high-quality, single A-rated issuers, where bonds currently trade at spread levels where BBB credits traded just one year ago. We regard this as a potentially lower risk-reward trade with a high probability of success.
- Overweighting US and European banks with securities lower in the capital structure. This takes greater advantage of the fundamental improvement within the financial sector, while the new issue supply outlook for AT1 capital securities and subordinated bonds appears more benign than that for senior bonds.
- Favoring bonds that fund large M&A transactions for multiple reasons, including:
- The credit event has already taken place, and these companies are now focused on de-leveraging their balance sheets.
- Companies are often forced to offer a large concession to get the new issue deal completed due to the size of the transaction.
- The liquidity in these deals is typically very good due to the size of the issues, allowing investors to adjust risk relatively quickly.
1 Source: Bloomberg, Sept. 18, 2015
Important information
Barclays US Investment Grade Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.
Yield is the income return on an investment.
An option-adjusted spread (OAS) measures the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option.
A subordinated bond ranks below other bonds with regard to claims on assets.
Additional Tier 1 (AT1) capital securities, issued by banks for regulatory purposes, typically offer higher yields than traditional bonds, but also carry higher risks if the issuing bank experiences severe credit problems.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.
This article was written by Jacob Habibi, Senior Analyst, Mike Hyman, Head of Investment Grade Portfolio Management and Matt Brill, Senior Portfolio Manager.