By Dwight Cass
But massive prefunding in the first half could mean that corporates can ride it out.
The capital markets in the second half started with both a bang and a whimper. The whimper came from bankers wondering how they would hit their nut when tumbleweeds were the only things moving through the bond markets. The bang was the door slamming as investors yanked money out of any bond or loan vehicle with any duration whatsoever.
No investment grade or junk bonds priced at all in the first two trading days of the half, when companies typically stampede to market. According to Dealogic data cited by the Financial Times, the third quarter kicked off with about $8 billion in issuance in its first two days. There wasn’t any this time around.
That’s not too surprising. The headlines on July 1 and 2 were nothing short of sepulchral for potential issuers and investors alike. Pundits screamed that investors pulled $9.6 billion from “bond king” Bill Gross’s flagship total return fund, reducing its assets by some 8 percent. Buy side research firm TrimTabs announced that bond mutual and exchange traded funds saw a record $79.8 billion outflow in June. And, while portfolio managers averred that there was no margin-triggered forced selling, cratering in the high-grade corporate and muni markets suggested otherwise.
Then came the Fed’s announcement that it would implement Basel III in more or less its entirety, offering no concessions to SIFIs other than a carve-out for residential mortgage capital, and promising a higher leverage ratio than the accord’s 3 percent. While most bank shareholders appeared unfazed by the announcement, the Fed’s plan will further reduce the sell side’s ability to act as the marginal buyer for secondary market debt, something banks have already scaled back sharply.
War chests
Corporates worried about interest-rate risk piled into the market in the first half (see related story), with investment grade credits selling $910 billion, a 10 percent rise over the year-earlier period. But the real action was in the junk markets, where issuance hit $2.8 billion, up 55 percent from the year earlier period.
Corporates ramped up prefunding deals as the impetus for “shareholder friendly” deals fell away with the resolution of the dividend tax question at year-end 2012. Corporates had done a fair amount of prefunding in 2012 also, bankers say, and this and the desire to buy off shareholders with fat dividends ranked total US issuance to $905 billion last year, according to Fitch, with nonfinancial issuance rising 41 percent year over year.
For most who did it, prefunding was wise. The high-yield bond market came to a screeching halt in June as the US Federal Reserve started hinting that it would taper off its bond purchases. This rippled through all the risk and spread markets, hitting emerging markets hard—and they were already getting hammered in some cases—and moving into asset classes that should be reasonably immune from interest-rate risks due to their short durations, like floating rate bank loans.
Even the leveraged loan market turned in negative returns in June, although it fell less hard than some others. The S&P/LSTA loan index returns fell by 0.59 percent in June, less than high yield, 10-year Treasuries, equities and high-grade corporates, according to Capital IQ.
The market turmoil also brought to a halt the loan covenant restructurings that borrowers were forcing lenders to accept for much of the past year. Call protection, change of control puts, maintenance covenants and other lender-friendly devices sprung up on the dwindling calendar of new loans, restructurings and bond issues.
What’s next?
Assuming the proximal cause of the market meltdown was in fact the Fed’s allusion to tapering its bond buying, some commentators have expressed the hope that the market’s violent swings would cause the central bank to retreat. And indeed, with some positive economic reports at the market’s back, spreads did narrow sharply on July 1. Positive manufacturing numbers on Europe’s periphery pushed the Markit iTraxx Europe almost 5 basis points tighter at 114.75 bps, and the Markit iTraxx Crossover rallied by 16.5 bps to 460bps.
But the numbers on July 2 appeared to embolden the Fed to yet more malapropos remarks. US manufacturing looked up: factory orders climbed 2.1 percent in May and April’s figure was revised higher to 1.3 percent from 1 percent. Housing looked like it was on a real roll, too. Corelogic reported that US home sales prices were 12.2 percent higher in May compared with May 2012.
“The Fed’s plan will further reduce the sell side’s ability to act as the marginal buyer of secondary market debt.”
In the wake of those reports, New York Fed boss William Dudley said, “I believe a strong case can be made that the pace of growth will pick up notably in 2014. The private sector of the economy should continue to heal, while the amount of fiscal drag will begin to subside. I also see some indications that growth prospects among our major trading partners have begun to improve.” He reiterated the earlier message about tapering, turning the market view of the positive economic indicators on its head and making them seem ominous. Still others have been trying to soften the blow (see sidebar below).
Fed puts metal to the backpedal
Since Fed Chairman Ben Bernanke first uttered the word “taper” to Congress back in May—and the subsequent rise in interest rates—several Fed officials have been looking temper the taper impact.
For instance, even though he has reiterated the tapering message, New York Fed’s Dudley (and FOMC voter) has also suggested that if “labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook—and this is what has happened in recent years—I would expect that the asset purchases would continue at a higher pace for longer.”
Likewise, Atlanta Fed President Dennis Lockhart (non-voter) indicated stimulus would continue. “To realize [the Fed’s] forecast or something close to it, monetary policy, which is ‘highly accommodative,’ will have to remain so for quite some time.”
And Fed Governor Jerome Powell (FOMC voter) also toed the walkback line: “I want to emphasize the importance of data over date,” he said. “If the performance of the economy is weaker, the Committee may delay before moderating purchases.”
Whether this sort of market flapping about fades away or leads to more significant outflows is impossible to say. Bankers are counting on investor need for yield to pull them out of cash and back into risk assets.
And clearly there has been some stabilization as asset managers move in to snap up what they see as underpriced bonds. Whether those investors are wise, or simply attempting to catch a falling knife, should become apparent when July’s flow figures are released.