Corporate bond investors rediscover duration but see spreads widening

No one would call 2023 an easy year in bond markets. Yet despite soaring yields, corporate bond issuers in Europe narrowly got away with paying lower average new issue concessions than the year before, suggesting that the market overall functioned well.

The average new issue premium paid in 2023 was 13bp, according to GlobalCapital’s Primary Market Monitor tool, down a touch from the 14.3bp average in 2022. PMM’s corporate section tracks all benchmark investment grade issues in euros and sterling.

The average new issue premiums of 8.4bp and 13.6bp in the first and third quarters were 2bp and 6bp inside those companies had had to pay a year earlier.

As of mid-November, even the fourth quarter had a better average NIP. That was despite October being a rough month — when conditions deteriorated, amid Israel’s conflict with Gaza, 10 year US Treasury yields hitting 5% and the ‘higher-for-longer’ signals about interest rates from central banks unsettling almost every financial market.

The few borrowers that did brave the market in October paid an average 25.8bp NIP, up from 19.3bp in the final quarter of 2022.

But although there was a burst of busy and more tightly priced issuance in November, investors say things will probably get worse for issuers before they get better. This is not necessarily just because of market technicals: investors have credit worries, too.

“A lot of companies didn’t feel the [economic] squeeze earlier,” says Nachu Chockalingam, senior credit portfolio manager at Federated Hermes in London, “but they are starting to feel increased pressures now — more meaningfully on the demand side and continued on the cost side.”

There is a lag between interest rates rising and that feeding through in higher borrowing costs for companies and households, cramping demand.

“Company fundamentals will become a top priority,” Chockalingam adds. “There are differences even within sectors. Take packaging — at the third quarter results, for example, metal companies are doing very well, but glass and plastics are doing poorly.”

Investors are having to cope with a complex and confusing landscape. “Economies have become somewhat desynchronised and we are also seeing meaningful dispersion across sectors,” says James Briggs, portfolio manager in the corporate credit team at Janus Henderson Investors. “Recent weakness in some of the more cyclical sectors — such as capital goods and packaging — [is] lagging behind the earlier slowdown in chemicals by almost a year.”

As interest rates rose sharply in 2023, corporate yields leapt. The average coupon on the benchmark IG bonds tracked by PMM hit 4.4% across all maturities, against an average of 0.38% in 2021, when the European Central Bank was in the last days of its bond buying programme.

That meant pockets of demand opened up in unexpected places, such as the short end of the curve, which had for some time been a place where only those who could stomach the skimpiest of yields and spreads would buy.

“It has been a year of carry for credit,” says Lloyd Harris, head of fixed income at Premier Miton Investors in London. “If you have been short dated and picked up that carry at the short end, you have been OK.

“There is an easy way to make money and a hard way,” he adds. “Short dated government bonds, short dated investment grade credit is the easy way. There is too much risk in longer maturities.”

A few senior bankers at some of the busiest corporate bond houses say they understand this attitude, because investors are not paid enough to take the extra credit risk of longer dated debt.

But the yield curve is that shape only because investors in aggregate want it that way. The idea that shorter is best is far from universally held.

“With the view of higher for longer, running a modestly long duration makes sense,” says Chockalingam at Hermes. “Curves are steep and will continue to become steeper. Curve steepening is the trend to watch.”

This is a stark difference from the years of ECB and Bank of England bond buying — which the market is only now recovering from — when the central banks’ presence homogenised credit risk, meaning curves could better be described as horizontal lines.

The stage during the present interest rate up-cycle of investors fearing duration is definitely waning.

“As yields have gone up, we have lengthened duration by 1.5 years,” says Adam Darling, investment manager at Jupiter Asset Management in London. “Back in 2021, yields were on the floor, and we were underweight duration.”

Bets like these are clear signs that investors believe rates will not rise much further and may even start falling. They are grabbing what may be a once in more than a decade chance to buy high grade corporate credit at yields close to 5% in euros, or even higher in sterling.

Although corporate bond issuers are having to pay much higher rates, investors’ pivot to duration does mean issuers have been able to flatten their curves.

Several have decided longer bond issues are a good deal for them, even if demand is not as deep as at the short end. Pharmaceuticals supplier Sartorius, for example, sold an €850m 12 year bond with a 4.25% coupon in September and Nestlé a €500m one paying 3.75% in November, while Ireland’s Electricity Supply Board issued a €500m 12.5 year in September at 4.25%.

This curve flattening was also visible during bookbuilds for multi-tranche deals, in how much issuers were able to tighten the different tranches.

French luxury goods groups Kering and LVMH, power and gas company Engie, Volkswagen and German electricity transmitter Amprion all found outsized demand for the longer legs of dual tranche trades during the summer.

Engie’s four tranche deal was a standout: it went as far as 19 years with a €900m 4.5% September 2042 bond that was tightened 10bp more than its four year tranche.

“It has not been the greatest year for credit,” Chockalingam says. “But investment grade is a safe carry trade if you are of the view that rates are approaching their peaks [and] will come down, which we are.”

The expectation of falling rates does not mean markets are out of the danger zone yet — far from it.

“The amount of fiscal expenditure so far is preventing a recession in the US,” says Harris at Premier Miton. The US government splashed out $6.13tr in the year to October 2023, $137bn more than the same period in 2022. This is set to hit $6.9tr in 2024.

This high spending has expanded the fiscal deficit to $1.7tr for 2023 — a 23% year on year jump and a record, except for during the Covid-19 pandemic.

“The Fed is not doing enough [tightening] to offset the fiscal expenditure, and we are not buying there being a soft landing, because we are already at maximum employment,” says Harris. “This means there is not enough slack to grow without more inflation.”

If the world’s largest economy slides into recession, it will almost certainly drag Europe with it — assuming Europe isn’t already stuck in its own quagmire.

“The market is saying nothing has really changed on long-term inflation expectations,” says Darling at Jupiter. A “lot of momentum” has come out of the US economy, he adds. “Is the US bankable? There is a lot of focus on the deficit.”

One way some investors are parsing the shaky market conditions headed into 2024 is that history tends to repeat itself, even with the added complexities of Covid-19 lockdowns and long-term quantitative easing to consider.

“A lot of leading indicators suggest that this interest rate cycle is no different from any other,” Darling argues. “Every cycle has its nuances — but, pre-Covid, why were people thinking that rates would be zero for ever? [The major problem now] is that there is so much debt. If you hike rates too much, this will start blowing up.”

This means more defaults coming among high yield borrowers. The possibility of default in investment grade is tiny, according to Darling — a view held by most of the market — but crumbling from investment grade into junk ratings is not, and then the default threat rises.

Nevertheless, there are still plenty of optimists out there.

“Corporate and household debt are not excessive — and assuming a sharp and/or globally coordinated recession can be averted, then a relatively modest rise in default rates can be accommodated by current spreads,” says Briggs at Janus. “Based on previous cycles, the conditions are broadly in place for credit spreads to widen, but the principal catalyst is yet to occur. With US growth surprising so materially to the upside in 2023, that catalyst may remain elusive in 2024.”