Slowdown in the pipeline

High-grade corporate issuance has dwindled from last year’s steady flow to little more than a trickle since the turn of the year. Richard Bravo looks at the implications for investors, many of whom are looking down the credit ladder for increased returns

The floodgates have been closed and the wells are running dry. Low-flying interest rates had most companies scurrying to the debt markets last year, taking care of their financing needs before the inevitable rise in rates would make money expensive again. But the slowdown has taken place earlier than anticipated. Contrary to most analyst expectations on the Street, supply in the investment-grade corporate bond market has already pulled back sharply from the frenetic pace that it sustained throughout 2003.

Although January is historically a busy time in the new-issue market, during the first month of this year, only $52.3 billion was priced in the investment-grade corporate bond market, down from $62.2 billion priced in January of the previous year, according to Thomson Financial. And further darkening the supply outlook, market professionals say that at least 90% of the debt priced in January was rated single-A or higher and came from supranationals, sovereigns and financial companies, not your traditional corporate bond issuers.

Poor performance

This tepid showing in the primary market contrasts strikingly with previous years. In 2003, global debt issuance, including ABS, MBS and taxable municipal bonds was $4.94 trillion, up $1 trillion from the previous year. Similarly, $659 billion was priced in the US investment-grade debt market, up 20% from the $549 billion priced the previous year.

Since 2001, when issuance hit a record of $667 billion for the year, companies have focused an inordinate amount of energy repairing long-neglected balance sheets, which were oftentimes blighted by mismatched liabilities. Corporations entered the capital markets en masse to term out short-dated debt maturities.

This endeavor has resulted in the lowest level of commercial paper outstanding in at least a decade. Since November 2000, non-financial CP outstanding has fallen by nearly 70% to $114 billion, according to Federal Reserve data. Treasurers were also induced to tap the credit markets because of record low interest rates, which enabled their companies to lock in favorable financing costs. 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%.

“A lot of corporations have cash and very low commercial paper balances and have pre-funded a lot of their maturities,” says Raj Dhanda, co-head of global debt syndicate at Morgan Stanley. “There is a lot of complacency about their access to money and there is still no visibility on their strategic needs. Even though the [mergers and acquisitions] dialogue has picked up, there is still a lag such that companies aren’t borrowing money to fund acquisitions yet. They have a lot of cash and can raise CP at very aggressive terms.”

In fact, with rates as low as they are, investment-grade companies can turn to a short-term debt market where the 90-day, tier 1 non-financial discount rate is hovering just above 1.00%.

Many market professionals are keeping their eyes on M&A activity to bring another wave of corporate financing to the forefront, but that market still has a long way to rebound. Since 2000, total M&A volume fell over 74% from $1.7 trillion to only $439 billion in 2002, according to Thomson Financial. But in 2003, volume picked up to $539 billion and analysts see further growth in the offing. According to data supplied by Standard & Poor’s, there has also been increased M&A activity among speculative-grade companies.

“In 2002 we had 49 first-time speculative-grade issuers and 77 in 2003,” says Diane Vazza, head of fixed-income global research at S&P. “And out of these issuers, only a handful in 2002 were acquisition related while 15 in 2003 were acquisition related. Access to capital was easy for speculative-grade companies and we expect that number will continue to grow in 2004.”

Down the ladder

The lack of supply in the high-grade market, in addition to continually shrinking yield margins, has sent investors looking further down the credit ladder in search of higher returns. At the end of January, the difference between speculative-grade and investment-grade spreads was just 294 basis points, considerably tighter than the 383 basis points averaged during all of 2003.

And the high-yield market has risen to the task of fulfilling the demand. In contrast to its higher-quality sibling, issuance in the high-yield market was the second busiest January for the sector on record. During the first month of this year, $11.24 billion was priced in the junk primary market, surpassed only by the amount of issuance during January of 2001, when $13.72 billion hit the market.

The search for yield has been a boon for high-yield companies who do not have as many financing options as higher-rated corporations. As Morgan Stanley’s Dhanda notes, “High-yield companies look at the world a little differently. They don’t have the option of the commercial paper market.”

In fact, KB Homes was able to find some very cheap money by selling $250 million of 10-year notes in the high-yield market last month. The transaction, which was rated Ba1 by Moody’s and BB+ by S&P and Fitch Ratings, was priced to yield 5.82%, or 1.75 percentage points over Treasuries. According to data supplied by FridsonVision, that was the lowest spread for a new high-yield issue since 1999.

Two other areas of the fixed-income market that are expected to succumb to a decreased level of issuance are the mortgage-backed securities market and the municipal bond market. In a survey recently conducted by the Bond Market Association, respondents expected mortgage-backed issuance to decline by a whopping 48% to $1.6 trillion.

“Thanks to a stronger economy, which began to exhibit measurable progress in the second half of last year, our members are expecting moderately higher interest rates during the course of 2004 and a corresponding expected drop in bond issuance,” said Micah Green, president of the BMA in the report. “2002 and 2003 saw record issuance in the bond markets and it was unrealistic for that to continue, especially in the mortgage-backed area which is so interest rate sensitive in the refinancing market. Nevertheless, despite the drop, 2004 is still expected to be the fourth or fifth strongest year ever for bond issuance.”

The BMA also expects that municipal bond issuance will wane in the coming year, with its survey concluding that supply will decrease by 11.3% from 2003’s level. As rates continue to increase, muni issuers will be less likely to refund old issues, said the BMA. Additionally, a stronger economy bodes well for future tax revenue, which would hold the potential of decreasing cities’ needs to finance in the muni market.

Technical issues

With investors flush with cash and corporate supply on the wane, the technical factors in the marketplace have become ripe for another spread rally, yet all indications are pointing to just the opposite. The auto sector, one of the darlings of the corporate bond market in 2003 and a corporate bellwether, has given up a considerable amount of ground since the beginning of the new year. Yield margins on Ford Motor Credit’s 7.00% paper due 2013, which was quoted at the beginning of January at 160 basis points over Treasuries, were trading as wide as 245 basis points over Treasuries in the middle of February, according to MarketAxess.

High-yield spreads have not been immune to the weakness. During the first weeks of February, speculative-grade spreads widened from January’s average of 366 basis points over Treasuries to 419 basis points over Treasuries, according to a recent report by Moody’s. Speculative-grade spreads had a mean spread of 387 basis points over Treasuries from 1993 to 1997 and during 2003 averaged 615 basis points.

“Spec-grade spreads, especially at the bottom end of the credit market, have looked unsustainable for a while,” said the Moody’s report. “At the end of last month, the median spread of seven-year Caa bonds was 525 basis points—around 270 basis points below the Caa average spread of 1993 to 1997. Those five years are generally seen as the salad days of the domestic junk bond market, when the credit quality was at its zenith and the market had a fairly strong appetite for risk. It is odd that the lowest of spec-grade bonds should now, at this stage of recovery for the credit cycle, be sold at spreads far narrower than those offered during the halcyon days of junk bonds.”

And many in the market attribute some of the spread weakness to the lack of supply in the primary market.

“The general level of spreads remains extremely tight due to a lack of new-issue supply. However, as we have seen in past markets, the level of activity in the secondary market has dwindled and there has been some easing of the spread tightening due to a lack of new-issue benchmarks to price the secondary market around,” says Jeff Kane, head of global high-grade syndicate at Banc of America Securities, who expects supply to be off 20% from last year. “It’s a bit of a contradiction that the lack of supply has allowed the market to remain tight but has added to a slowdown in activity and a lack of direction.”

However, the weakness in the market seems to fly in the face of the fundamental credit situation. Moody’s recently announced that the US high-yield default rate was only 5.4% for the 12 months ended January 2004, down from 6.0% in January 2003. There has been an 18% year-over-year decline in the number of US high-yield downgrades for the period ended January 2004. Conversely, the upgrade ratios of credit ratings revisions have increased from 35% in 2003 to 45% in terms of count to date, and from 2003’s 29% to 51% in terms of par value amounts.

Although appetite for new issues remains, investors are also aware that interest rates are poised to ascend from their near 45-year lows; and with portfolio managers scrambling for whatever incremental yield still remains, the extra yield that will provide the primary market almost seems seductive enough to wait for.