On average an investor is paid a premium for participating in new issues, along with attractive pricing and better access, making it more attractive to purchase in primary or soon after. In this note, we highlight the opportunity and how investors can achieve better returns as a result.
Background
There are many benefits for an investor to participate in primary markets, which is where a new bond is brought to market and prior to it trading between buyers and sellers (which is referred to as the secondary market). There is generally an extra spread offered by the issuer to incentivise investors to participate in the transaction rather than buy a similar bond in the secondary market. This premium is the difference between the primary issue yield on the bond and the yield on the same bond subsequently traded in the secondary market.
There are factors that will determine the size of the premium, and if there is a premium offered at all. The size of the issue, market conditions, and appetite for the credit are some of the determinants.
This also means the bonds typically are offered at a more attractive entry point than if purchased on the secondary market, with most new issues pricing at a clean capital price of $100 (referred to as par). Following this when a bond begins trading, the price can move higher or lower (and the yield will reflect this), although as we show, more often than not it’s a case the price moves higher (and the yield lower).
As part of the new issue process, the bookbuild allows an investor to bid their preferred size into the issue, with bonds readily available and better access than what the secondary market can generally offer. However, we also note that due to strong demand, new issue bids can be scaled.
Currently, it’s a perfect storm for primary markets, where a series of rate hikes from Central Banks (including the Reserve Bank of Australia), has resulted in elevated yields on offer fuelling insatiable demand for new issues at higher returns. Yet despite strong investor demand tightening yields on new issuance, it seems investors are still paid a premium for purchasing newly issued bonds, as we discuss further below.
New issue premium
Over the past year (and longer) we’ve seen strong participation in primary debt issues, where order books have exceeded the issue size and final pricing is revised tighter. For example, the recent Lloyds Banking Group’s 2028c Tier 2 subordinated note had a bookbuild in excess of $1.2bn, raising only $750m and priced at asset swaps plus 290 basis points (bps) from initial guidance of 300bp to 310bp.
There are many more examples of this, but the point to make is, that despite pricing moving tighter, in most cases there remains a premium that is squeezed out the longer the newly issued bond trades in the secondary market.
The table below shows the issue margin of Tier 2 subordinated bonds issued this year in AUD, which has mostly dominated the primary markets this year (aside from Asset Backed-Securities and Residential Mortgage Backed Securities new issues), compared to where the margin is trading at the time of writing (taken from 28 August 2023).
The chart illustrates the change in the bond’s margin, remembering that a lower margin (yield) results in a higher price (all other things being equal), as it trades in the secondary market post-issuance. It’s worth noting that with risk-on in markets generally this year, credit spreads have tightened, accounting for a portion of these moves in issue margins. Allowing for this and general market moves, there is on average about a 40bp differential that can be attributed to new issue premium.
Although it still identifies on average there is price appreciation attributable to the margin when it trades in the secondary market, and more specifically this typically happens the longer it trades in the secondary market, all else being equal. This means that even after the issue date it is worth topping up an allocation if the bid at primary was scaled to a lower-than-desired amount.
Therein lies an opportunity to lock in higher returns by participating in the issuance at primary or purchasing on average within a 30-day window following its trading in the secondary market. Following this, there has been a more significant move tighter as initial supply soon after primary is exhausted, and demand spurs the price higher.
Where the case is that new issues have been scaled in primary due to over-bid order books, the subsequent 30 days provide an opportunity for investors to top-up allocations in secondary trading while the premium is somewhat still priced in.
As mentioned, not all new issues experience an uplift in price when they trade in secondary as there are some exceptions. However, where the case exists, and depending on how significant the price appreciation is, this can also provide an opportunity to exit the position and lock in any capital gains.
Improved pricing
An added benefit of participating in new issues is the attractive entry price that can be achieved. Typically, new issues are priced par, which is also often the redemption price come maturity (noting there are exceptions to this rule).
New issues have generally performed well when traded over time in the secondary market on strong demand, also noting there has been a lack of new issuance throughout this year that has also fuelled the solid appetite.
This has generally resulted in price appreciation, although noting this typically happens the longer the bond has been trading in the secondary market, allowing a window where attractive entry levels can still be achieved soon after issuing.
The table below illustrates the change in price from the bond’s issuance to the indicative price at the time of writing (taken from 28 August 2023), which shows the change in pricing.
In most cases, the bond’s price has moved higher since issuing, which also creates a capital gain for the noteholder if they were to exit the position.
Accessibility
In some cases, bonds can become scarce in the secondary market, or harder to source as noteholders are happy holders and less willing to sell. This can mean that investors looking to buy such a bond could be waiting a period of time or paying a higher price to obtain an allocation. However, when a new issue comes to market, there is a good level of accessibility that makes it an attractive proposition.
The size of new issues can vary, with some smaller higher-yielding transactions around AUD30m in size, while others provide a good level of liquidity at up to $1bn in size. The recently issued Pepper Money Limited Tier 2 subordinated issue was for $40m, while the Lloyds Banking Group issue was $750m as mentioned, providing a good pool of access for investors.
New issues are readily available bonds, where investors can bid into the bookbuild, although noting where there is strong demand, allocations can be scaled.
Conclusion
Issuers typically offer a premium for new debt raisings, to entice investors and ensure a strong level of participation for the deal. Even when pricing has revised tighter in primary as a result of strong order books, it has been shown that on average the margin has tightened further in secondary trading. More so, new bonds brought to market are issued at attractive pricing, typically $100, and the accessibility of bonds is another added benefit.
