Improving market conditions and higher retail fund flows are fueling an issuance spike. Can markets digest the increase in supply?
Credit market performance gathered steam in April amid a much improved backdrop for US economic growth and earnings expectations, increasingly accommodative global central bank rhetoric and even a pickup in some commodity prices, especially oil.
For high yield bonds, yields and spreads have decreased 2.66% and 257 basis points since mid-February to 7.44% and 582 basis points, or 6.73% and 516 basis points, if you take out the energy and commodity companies (as of April 29). In April alone, yields and spreads were down another 74 basis points each. Along with improving market conditions, technicals, such as increased bond issuance and higher retail fund flows, have played an important role in the rebound.
The recent pickup in high yield issuance is not surprising given the new-issue market came to a near halt earlier this year as extremely wide spreads and lack of demand sidelined would-be issuers. Total new-issue supply for 2016’s first quarter was $37 billion, down 57% versus the first quarter in 2015, as weak macroeconomic factors and poor liquidity conditions prevailed.
In March, as the macro environment improved, signs of a healthier technical picture emerged and the new issue calendar grew. A little more than half of the first quarter’s issuance came in the last few weeks of March as risk markets rebounded. Coincidently, demand for higher-yielding investment alternatives increased and spreads compressed further, spurring another round of issuance.
Typically, greater issuance would force high yield spreads wider but, in today’s low-yield world, investors are hungry for income, allowing the market to easily digest the increase in supply. Investors started to pour back into the market as liquidity improved and the primary market presented new opportunities.
March saw exceptionally strong inflows into both high yield exchange-traded funds and mutual funds, including a record $4.97 billion during the first week. This technical dynamic gave the rebound breadth and contributed to the snapback in spreads.
A Spike Ahead?
Keeping with this trend, these two technical factors have continued into April and, in our view, will likely persist. Some $33 billion was priced in April, surpassing issuance in March and nearing the issuance of April 2015. Fund flows in April have been positive for the first three weeks of the month. However, if markets continue to accommodate the new issues and volatility remains low, issuance could spike as the backlogged high yield pipeline grows.
In addition, fund flows could stabilize as the market nears fair value, which we estimate to be between 575 and 675 basis points on a spread basis. This may lead to underperformance at times, but we believe that high yield valuations are still attractive at these levels on a historical basis and any sell-offs would create buying opportunities. Therefore, investors may not see price appreciation in their bonds, but will be able to clip a coupon at the current elevated yield levels. Indeed, 2016 could turn out to be a “coupon year.”
With a current yield of 7.44% on the Barclays Corporate High Yield Index, that’s a pretty good deal.