The impact of the coronavirus on business has been unprecedented. The huge amount of uncertainty around future cashflows of businesses across all sectors has meant that conservatism from managers is the order of the day.
What this has meant in terms of the credit markets, defined as bond markets which contain credit risk as opposed to government bond markets which are assumed to be credit risk free, has been that companies have been looking to shore up their liquidity positions to ensure they have sufficient cash on hand to survive this period of lower revenues and eventually emerge on the other side with a viable business.
The way that these businesses with the ability to access capital markets have gone about it has been twofold – but both involve capital raisings, either equity or debt. Clearly, we are interested in the debt side.
New issuance of debt (or equity for that matter) traditionally comes at a more attractive level to the investor than existing securities in the secondary market. This is to provide an incentive to investors to purchase the new securities rather than simply buy existing ones.
Traditionally in the bond market this ‘new issue concession’ has come in the form of a higher yield than would be expected based on the existing securities in the market (both from the issuer and comparable bonds), for a given maturity.
This can be seen in the chart below, for the recent Brisbane Airport issue (new bonds in yellow):
A strong new issue concession serves dual purposes:
- Clearly it entices buyers of the new securities – this is its purpose after all
- It also ensures that the issuer will retain secure access to the capital markets, as investors will be confident in the performance of the securities once they have bought them.
This may cost the issuer a few extra basis points in interest cost on a periodic basis, but is well worth the expense when raising capital in a stressed market, and may be the difference between the survival or failure of a business, not to mention between a relatively normal interest rate demanded by the market versus one where the market knows the issuer is at their mercy.
A note on style:
Remember that the institutional bond market, which controls pricing of these larger, usually investment grade issues, is typically benchmark driven, and so any extra return versus a fund's benchmark will deliver ‘outperformance’ for the fund.
Absolute return philosophies in institutional fixed income are rare (particularly in Australia) given the conservatism of the sector, as well as the ability to have large mandates removed from funds at short notice if this underperformance related to the benchmark is a regular occurrence.
As stewards of your own capital, it is impossible to remove your own mandate. This gives private investors a valuable advantage as they are typically able to see through movements in price of bonds, and focus on the return of and on capital, without having to be concerned about having that capital removed from their management, along with the reduction in fees earned.
Recent new issuance:
The above style note means that absolute performance can be strong in new issues even with what may be considered a relatively low coupon from a private investor's viewpoint.
We will look at three recent new issues, two locally and one in USD:
- Woolworths issued a 10 year bond with a coupon of 2.8% on the 20th of May
- Brisbane Airport also issued a 10 year bond on the 25th of June with a 4.50% coupon, and
- BP Capital (the funding entity of the BP Group) issued a USD 10 year callable bond on the 22nd of June.
The chart below shows the price performance of these three bonds since issue.
With all being 10 year maturities (or priced to the 10 year call for BP) and fixed rate, they do have a greater sensitivity to lower yields (which increases price due to the inverse relationship between price and yield) than shorter dated or floating rate bonds.
Returns for these three bonds are below:
Clearly the annualised returns look extremely attractive but remember these are inflated due to the extremely short period of time since issue.
However, for the trading client, these can present excellent opportunities to generate excess returns by rolling into and out of these issues on a short-term basis.
Historically, as market rates as well as credit margins have fallen, this strategy of rolling new issues to pick up the concessions has generated returns well above 10% p.a.
Of course, it is important to remember that this is not an exact science, and the market may not move immediately in the investor’s favour.
The upside in those cases that do not see early capital price appreciation are that you get to hold a safe investment grade bond providing a good income stream for a longer timeframe – not exactly the worst outcome in a period of low interest rates.
Conclusion:
Participating in new issues which look attractively valued (even potentially with a lower than desired headline coupon rate) can result in investors picking up capital gains as the new issue concession is priced away by the secondary market.
A strategy of rolling these new issues may produce excess returns.
New issues such as these often open and close quickly, sometimes in a matter of hours.
It is therefore imperative that current and prospective clients stand ready to participate.
For new clients this is particularly important, as it requires an account open and to be ready to trade.
If you think you may not be set up and ready to take advantage of new issues as and when they arise, please call us on 1800 01 01 81 or get in touch with your Relationship Manager to open an account.