Wednesday, 12 December 2018

The attraction of a long curve

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Creating perfect conditions for the US investment-grade bond market

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The US investment-grade bond market is poised to experience some extraordinary changes in the year ahead, as the Federal Reserve’s withdrawal from its bond-buying programme comes into effect and as Europe starts to challenge the US as the place where corporates can get the cheapest cost of long-dated funds.

Throughout 2013, the euro market saw a steady stream of US corporates choosing to issue long-dated bonds and swapping them back into dollars at a cheaper all-in cost than had they simply issued US dollar bonds at home.

The trend has been growing in the past six or seven months, as the basis swap has collapsed at the intermediate and longer end of the curve. By the end of 2013, the five-year basis swap had dropped to –12bp from around –30bp at the beginning of the year, while the 10-year had gone from around –26bp  to –11bp.

“The cost benefits seem to manifest themselves, depending on the credit, in the seven and 10-year part of the curve and longer,” said a head of DCM at a major US bond house. “In those cases we would say the swap to dollar equivalent is better than what these kinds of sophisticated borrowers can achieve by issuing outright in dollars, and for some as much as 15bp–20bp better.”

“The European market is a little bit like where the US was 12–18 months ago, when rates weren’t going higher and credit is a  good place for investors to be,” said one syndicate manager in New York. “The geopolitical and policy outlook has stabilised, so the European buyer base has become much more reliable and their interest in highly rated US credits continues to be high.”

A better European market also means fewer European corporates coming to the Yankee market, as experienced in 2013.

Yankee financial issuance was up in 2013, at 155 deals for US$204.7bn compared with 2012’s 171 issues for US$193bn, according to Thomson Reuters data. But corporate Yankee deals were lower and dragged down the total. Yankee corporate supply dropped to 102 deals for US$146.5bn, versus 2012’s 143 issues for US$177.5bn.

Yet bankers in the US might still be able to argue that the US market is much deeper than euros at the long end of the curve, with corporate pension funds and insurance companies pouring increasing amounts of money into bonds.

France’s EDF attracted over US$11bn of demand for a US$4.7bn issue of senior unsecured notes from three to 100 years in maturity in the second week of January, and another US$6bn piled in the next day for its US$1.5bn offering of  perpetual non-call 10-year hybrids.

The demand for EDF’s bonds speaks to a new phenomenon influencing fund flow dynamics in the US market, where the US’s 100 largest corporate pension funds are reducing their equity exposure and increasing their fixed income purchases at the long end of the curve. This so-called ”reverse rotation” is being driven by funds seeking  to de-risk portfolios that have for the first time in years been boosted to almost 100% fully funded status, thanks in part to a strong equity market.

This demand, along with increased appetite for long-dated bonds from insurance companies attracted by higher all-in yields, has already provided a countervailing force against the negative effects of last year’s retail outflows from long-duration bond funds and ETFs. The result has been a US market that can boast of deal sizes not normally achievable at the long end of the curve in euros or sterling.

EDF chose to offer relatively generous pricing for the 30 and 100-year tranches of its trade because of plans to tap the euro and sterling markets immediately after its trek to the US.

But, in general, the demand for 30-year paper, while interest in the intermediate part of the curve dwindles, is helping to drive the 10s/30s credit spread differential tighter.

By the end of last year, the spread between 10 and 30-year corporate bonds had dropped from 30bp to 12bp, according to Eric Beinstein, head of investment-grade credit strategy at JP Morgan, as pension funds anxiously increased their bond investments to lock in a sudden surge in their funded status. “The rotation is not so much a move from fixed income into equity en masse, it is from less retail to more institutional investors in the investment-grade market, and that’s led to tightening spreads between 10s and 30s,” Beinstein said.

Pension funds have not historically reacted to a fully funded status by selling equities and buying bonds to lock in their positions, but given the huge losses they suffered during the crisis, more have embraced liability-driven investment strategies.

“Given the experience of an unprecedented degree of underfunding and new pension regulations that require companies to make up gaps in funding, we expect that many companies will in fact do the reverse rotation this time,” said Hans Mikkelsen, senior credit strategist at Bank of America Merrill Lynch.

The bond market started to feel the effects of the reverse rotation in the latter half of 2013.

“A lot of the strength in the investment-grade market in the second half of 2013 was related to pension fund de-risking flows, so this move has already begun, and we expect it to continue to grow,” said Sivan Mahadevan, head of credit strategy at Morgan Stanley.

About US$174bn of 30-year investment-grade bonds were issued in 2013, according to Barclays, versus US$156bn in 2012.

Danielle Robinson




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