Over the past several years, two trends have reshaped the market for U.S. investment grade (IG) corporate bonds: a significant increase in the size of the market (both in number of issuers and issues and in aggregate debt outstanding) and a contraction in dealer balance sheets.
The proliferation of issuers and issues is a response to several conditions in the economy and markets. Ultra-low government yields, global quantitative easing and cash-flush investors have generated a highly favorable environment for small corporations to issue debt. Investors who historically would have passed on an inaugural issue of a small company are now willing to participate in order to put cash to work.
Bond managers are another source of increased demand for IG debt: Generally stable flows into bond mutual funds and ETFs have managers purchasing bonds in the primary market in order to stay fully invested. Small and large corporations, noting a near insatiable appetite for risk assets, have responded by issuing more debt for M&A activity and stock buybacks.
While the overall size of the market has increased over the past decade, the favorable environment for smaller companies means the average size of each issue has actually decreased (see Figure 1). In 2004, the U.S. investment grade market (specifically for issues greater than $250 million) comprised 2,797 issues totaling $2.0 trillion outstanding. By 2014, there were 5,769 issues totaling $4.8 trillion outstanding. During this time period, the average issue size decreased from $797 million to $693 million. In short, there are a lot more “small” issues (relatively speaking) for traders and portfolio managers to actively monitor.
Along with issuance, trading volume in U.S. IG corporate debt has risen over the past several years – but not as quickly as the aggregate size of the bond market. As a result, average daily turnover per bond has actually declined by approximately 32% since 2006 (according to Citigroup as of 31 December 2014) and appears to be increasingly concentrated in a select number of large recent issues. This is in part due to the second key trend: Broker-dealers are holding less inventory, and, in some cases, stepping back significantly from market making.
Broker-dealer caution continues
In the wake of the financial crisis, broker-dealers are less inclined to warehouse risk and move corporate bonds among investors, a trend that could affect liquidity in certain areas of the market. Net dealer inventory of corporate bonds with maturities greater than 13 months, after peaking in 2006 around $31 billion, is now around $18 billion. Volumes of single-name credit default swaps (CDS) have declined significantly as well, with the gross outstanding peaking in 2008 at $26.7 trillion and falling to $8.6 trillion in 2014 (according to the latest data available from the Bank for International Settlements). Finally, several previously active dealers have de-emphasized their market making activity. A variety of factors have contributed to this trend, as post-financial crisis regulation has forced banks to meet increasingly stringent capital and leverage restrictions.
Security selection and liquidity management are as critical as ever
The recent increase in issuers and issues makes security selection an important component of an actively managed corporate bond portfolio. All things equal, a greater number of issues increases the possibility that any given issue is mispriced: either too rich or too cheap. As cash-flush investors pile in to new issues, securities tend to price in line with levels suggested by the ratings from the official credit rating agencies.
However, relying on agency ratings alone can be fraught with risk, as many investors learned in 2007–2008. At PIMCO, our credit analysts generate in-house ratings. These ratings are forward-looking, incorporate our firm’s view on the companies and the sectors in which they operate, and they can dramatically deviate from the agencies’ ratings. These internal ratings, along with associated in-depth research notes and valuation, form the basis of our credit selection process. As the credit market has expanded in recent years, so has our global team of credit analysts, which has grown by almost 40% since 2011. (For more on PIMCO’s approach to credit analysis, please read the May 2015 Featured Solution, “The Credit Analysis Process: From In-Depth Company Research to Selecting the Right Instrument.”)
In addition, we are active, but selective, in the primary market. Our credit analyst team’s rigorous on-the-ground research and deep relationships with the management of many global issuers help pinpoint attractive primary market opportunities.
Risk management should be a consistent focus for credit investors, and as the market expands in both size and complexity while broker-dealers continue to limit inventories, portfolio liquidity management (i.e., ensuring accounts have sufficient liquidity at all times) becomes a core component of risk management. As securities age in PIMCO’s credit portfolios, we tend to rotate out of less liquid securities as opportunities arise and/or we conclude we are not being sufficiently compensated for liquidity risk. Our objective is to have sufficient “dry powder” ready to deploy the next time an attractive new issue comes to market. As part of this process, we look carefully at the basis – the difference between the spread (over Libor) of corporate bonds and the spread of their corresponding credit default swap (CDS) – as an indicator of whether we are receiving adequate compensation for holding corporate bonds in relation to CDS.
Ensuring accounts are sufficiently liquid, in our view, is akin to buying attractively priced options: Portfolio liquidity can allow the investment management team to take advantage of opportunities as they arise.
We believe the proliferation of U.S. investment grade issuers (and issues) and the simultaneous contraction in dealer balance sheets has created both risks and opportunities for credit portfolios. Security selection and liquidity management are as critical as they have ever been in active corporate bond portfolio management.