Primary concerns

The dynamics of the primary market are such that portfolio managers are finding it increasingly tricky to tap into new issues. Their predicament is not being made easier by the fact that corporate supply is dwindling, as Richard Bravo discovers


Since the turn of the century, portfolio managers delving into the investment-grade primary market have witnessed any number of evolving supply scenarios, from blowout deals with wildly oversubscribed order books to the complete inability of companies to access investor money. But the current environment, which is attracting some new, big money investors while at the same time alienating riskier segments of the market, is becoming more difficult for money managers to tap into.

The vague specter of rising interest rates has been dashed with the cold reality of increasing Treasury yields. New yield-laden issues, however, have induced large insurance companies to snap up new deals at a time when corporate supply is ebbing, making it tougher for portfolio managers to realize their desired allocations.

The fact that issuance in the US investment-grade market has risen marginally is somewhat misleading, insofar as a healthy portion of the supply coming to the market is financial debt. According to data supplied by Thomson Financial, $235 billion has been priced in the US high-grade corporate bond market so far this year, up from $230 billion during the same period in 2003. But the flow of debt into the market, excluding banking and finance and insurance paper, was down nearly 55% in the first quarter of this year compared with the first quarter of last year, according to Fitch Ratings, a decline from over $61 billion in the first quarter of 2003 to $28 billion in the first quarter of 2004.

And by the end of April, the supply outlook continued to look bleak. April issuance of US investment-grade corporate bond debt tumbled to $32 billion, according to Thomson, the lowest level since August 2003, which is typically a slower supply month. In April of last year, nearly $50 billion hit the new-issue market. And by the end of the first week of May, the high-grade market had its fifth straight week of less than $10 billion in new supply.

“The lack of supply is due to the fact that companies are well funded and do not currently need to tap the debt markets,” says Mariarosa Verde, managing director of credit market research at Fitch. “We have done research on hundreds of US industrial companies and have found that most had very healthy levels of cash on balance sheet at year-end.”

Companies built up cash supplies from record issuance volumes in 2002 and 2003 and from excess cash produced as a result of improving profitability this past year, says Verde. In 2002 and 2003, respectively, $549 billion and $661 billion was priced in the US high-grade market, according to Thomson.

Furthermore, many companies have been hard at work repairing long-neglected balance sheets, an effort that began to take hold in the latter half of last year. Many corporate treasurers are still wary of the not-too-distant past, when access to the capital markets was much more difficult. As a result, cash holdings relative to debt have risen dramatically over the past year and a half. Yet many market professionals remember back to March 2002 when Bill Gross, manager of Pimco, the world’s largest bond fund, publicly rebuked GE Capital for the amount of commercial paper it had outstanding. At the end of 2001, GE Capital had $117 billion of outstanding commercial paper compared with its total $240 billion of outstanding debt. GE shares fell nearly 3% after Gross’s public comment, and heralded a marked increase in attention to companies’ liquidity. By early 2003, GE had pared back its commercial paper load by 30%. As more and more companies were shut out of the commercial paper market, corporate treasurers started down the road to repair their long-neglected balance sheets.


In addition to a convalescing fundamental outlook, technical factors in the marketplace have strengthened as well, making the primary market hospitable to companies that do want to tap the corporate arena.

“There has been a degree of stability in the market all year,” says Sid Bakst, portfolio manager at Weiss, Peck & Greer. “Fundamentals are positive, earnings-wise and balance sheet-wise, but much of what we’ve seen has been more technically driven. There are more dollars chasing less issuance on a fixed-rate basis. There really isn’t as much new supply entering the market.”

The modest amount of supply to hit the primary market has also had an effect on the secondary market, with technical factors helping to ratchet spreads ever tighter. Yield margins for Baa long-term industrial credits currently are at a median of 134 basis points over Treasuries, according to Moody’s Investors Service. At the beginning of the year, that median spread was at 150 basis points over Treasuries. The current level is still wider than recent levels, however. Between 1993 and 1997, Baa rated credits averaged 125 basis points over Treasuries. But the current average is arguably the narrowest that it’s been since the spring of 1998 and does not bode well for continued tightening.

“One of the implications would be there is a much diminished scope for further narrowing, suggesting that [spreads] are less likely to outperform Treasuries,” says John Lonski, chief economist at Moody’s. “The latest narrowing has been in anticipation of the continued above-average earnings growth and borrowing restraint.”

Yet the market conditions are still ripe for companies that do choose to sell debt. Expectations have morphed from whether the Federal Reserve will raise interest rates, to when and by how much. But currently, rates are relatively low. Since January 2001, the Federal Open Market Committee has cut its target for the federal funds rate 13 times from 6.50% to just 1.00%.

“Money in the investment-grade market is still looking attractive,” says Diane Vazza, head of global fixed-income research at Standard & Poor’s. “Six months ago we thought the financing window wasn’t going to be attractive in the second half of this year but we gained an extra six months in terms of the window. Money will be more expensive relatively, but still good.”

This perception has been borne out by the ability of companies to get large deals done with a certain degree of ease. In late April, DuPont tapped the market for $1.4 billion of six- and 10-year notes in anticipation of debt maturing in the near term. While the deal wasn’t a blowout, the company did not have any trouble marketing the issue to investors. But buy-side players have taken note of the fact that new deals are “priced to perfection”. Sallie Mae even priced $1 billion of 10-year debt recently, at a yield margin of 91.5 basis points over Treasuries, which gave many investors pause, because pricing a deal down to half a percentage point is not a regular occurrence in the high-grade market.

“Despite the low level of new supply, deals are coming priced so perfectly,” says Steve Nelson, portfolio manager at Axa Investment Managers in Minneapolis. “They are fairly rich for a lot of buyers. There is a lot more appetite brought into the market and getting a nice allocation on deals is even harder.”

Insurance companies

Another factor that is cramping the new-issue market is that with the sudden move in Treasury yields, insurance companies are beginning to eye the corporate bond market. In the beginning of April, the 10-year Treasury yield was at 3.88%. Just a month later, the benchmark security was trading at 4.56%. This dramatic move in yields has drawn larger players back into the corporate bond market, as they are now able to hit their yield targets.

In 2003, 15% of Lehman Brothers’ trading volumes were with insurance companies, says Rick Rieder, head of global credit business at Lehman. This figure dropped to 7% in January and February because of where rates and spreads were, but in March it ran up to about 12% and in April it reached 22%.

“Insurers are putting a lot more money to work because of the rate backup,” says Bakst from Weiss, Peck & Greer. “Hedge fund money dropped but different players are playing. There is money out there looking for a home and insurers are leading the charge.”

Some analysts don’t expect the dry spell to alleviate anytime soon. Companies are still wary of their balance sheets and until they start spending more money, a large flow of money into the primary market is unlikely.

“For these well-funded investment-grade industrial borrowers, a pickup in incremental borrowing is not likely to kick in until economic activity warrants deeper infrastructure, inventory or other strategic investments,” adds Verde. “To date, we have yet to see a really big increase in capital expenditures. In fact, I predict investors will continue to have difficulty finding investment-grade supply for the remainder of this year.”

But an increase in capital expenditures and mergers and acquisition activity should boost supply in the near to immediate future. According to Moody’s Investors Service, business investment spending is expected to grow by 10% this year. Additionally, the year-to-date dollar value of targeted business acquisitions in the US increased by 175% over the same period last year.

Standard & Poor’s also believe that the outlook is far from bleak. “We expect supply conditions will remain good through the remainder of 2004, notwithstanding an increase in rates,” says S&P’s Vazza. “Depending on the Fed action, there could be some spillover into the first quarter of 2005. Six months ago we thought the financing window wasn’t going to be attractive in the second half of this year but we gained an extra six months in terms of the window. We had really good numbers last year and if [supply is] up slightly, that’s still a great year.”

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