Composition of Fixed Income Indexes and Primary Issuance

We spoke with Income Research + Management to discuss how the credit quality of the U.S. Investment Grade Corporate Index has changed over the years, along with primary issuance. Highlights from the discussion include securitized exposure of the US Aggregate Index, the increased number of mega deals, and reduced secondary trading on primary issuance.

Rob Lund, CFA
SVP, Client Portfolio Manager
Income Research + Management | www.incomeresearch.com/
Rlund@incomeresearch.com

SAA: How has the credit quality of the U.S. Investment Grade Corporate Index changed over the years and how should investors think about these changes?

IR+M: In the last four years, the US corporate bond market has experienced significant growth, expanding nearly 50% to $5.8 trillion.1 The change has been the most pronounced in the BBB category, which has grown from 42% to 48% of the corporate sleeve of the US Aggregate Bond Index.1 This growth has been largely fueled by downgrades related to M&A and commodities.

CVS’s rating, which issued $40 billion in debt in March to finance its Aetna acquisition, is now on watch for a downgrade. AT&T’s rating, which will have $180 billion in debt outstanding after purchasing Time Warner, is similarly at risk. The overall credit quality of the investment grade market – and its indices – is migrating lower.

In the last 10 years, the BBB- segment of the US Corporate Bond Index has increased from 8.6% to 12.7%.1 Of this 12.7%, the largest component is energy, followed by consumer and communication. The average net leverage of the Index continues to rise, with BBB rated bonds accounting for more than all of it.

In many indices that contain both corporate and government components, increased Treasury issuance has diluted the corporate segment. With a record first quarter in net borrowing, Treasury issuance seems unlikely to slow down soon, especially given the government’s massive fiscal stimulus plans. As a result, this pattern of dilution could continue for the foreseeable future.

For investors who desire exposure to corporate bonds in particular, corporate-only or custom indices may provide more relevant exposure than the traditional broader indices.

SAA: Is the securitized exposure of the Aggregate Index representative of the opportunity set available to investors and are there out-of-index sectors where active managers can add value?

IR+M: While the US Aggregate Index may best represent the securitized universe, with a 30% allocation to mortgage-backed securities (MBS), the Aggregate Index does not accurately reflect the broader opportunity set.1 The rules governing the Aggregate Index have resulted in a concentrated exposure to the residential mortgage market.

Nearly 30% of the Index’s securitized exposure is wrapped by GNMA, which is a de facto lender of last resort that carries an explicit government guarantee.1 These securities, which have no structure or underlying prepayment penalty terms, have significant convexity risk. The Index uses generic cohorts, which are defined by issuer, loan term, vintage, and coupon, to approximate the outstanding float in the US agency mortgage market.

Bottom-up security selectors can be more discriminating, and focus on securities whose characteristics (i.e. low FICO scores or loan balances) mitigate prepayment volatility. The Aggregate Index’s inclusion rules also prohibit 144a securities, and place minimums on deal and tranche sizes.

Active managers have access to an extensive out-of-benchmark opportunity set that can help generate outperformance. These opportunities, which are not part of the Index, include Small Business Administration bonds, equipment asset-backed securities (ABS), and non-agency jumbo 2.0 collateralized mortgage obligations.

A significant portion of ABS deals are precluded from the Aggregate Index due to its restrictions on floating rate and 144a securities. Rather, the Index includes ABS deals that are large, fixed rate, and public, and typically backed by auto loans, floorplans, and credit cards.

Including more unique ABS deals that are backed by collateral such as single family rentals and equipment leases, in addition to SBAs and non-agencies, allows portfolios to be ratings neutral to the securitized portion of the Index. Additionally, they diversify one’s collateral exposure, and are less negatively convex than Agency MBS due to the structural features.

SAA: What is driving the increased number of mega deals in the market over the past several years? How does this impact not only the corporate bond market, but the quantity and quality of CLO issuance?

IR+M: While the estimates may vary, the theme remains the same. Mergers and acquisitions (M&A) issuance, which was more modest in 2016 and 2017, has rebounded in 2018.1 With approximately $200 billion of supply in the pipeline, M&A activity has spiked due to a reduction in the corporate tax rate, as well as a discounted repatriation rate.

Additionally, the antitrust issues surrounding the AT&T and Time Warner merger were recently resolved, clearing the way for other potential mergers, such as Disney’s proposed purchase of Fox. We are closely monitoring the rise of M&A activity, given that the economy is in what we believe to be the later stages of the credit cycle.

An increase in debt-financed M&A has had an adverse impact on issuers’ balance sheets, which is a credit negative. With the number of passively managed funds on the rise, issuers are being well-received by a less discriminating investor base.

In an estimated half of recent earnings calls, issuers mentioned M&A as a potential use of additional cash from tax reform. M&A activity could reach a crescendo later this year, with the healthcare, food and beverage, and consumer sectors leading the way.

Increased M&A could have a positive effect on the supply of collateralized loan obligations (CLOs), which are comprised of leveraged loans. This year, CLOs have struggled to source quality collateral.

A strong M&A environment could lead to an increase in leveraged loans, which could contribute to fuel the formation of new CLOs. In 2017, CLO issuance in the US exceeded $118 billion. In 2018, issuance is projected to reach $150 billion – a nearly 30% increase year-over-year.1

SAA: Given reduced secondary trading and strong investor demand are you seeing an availability premium placed on primary issuance?

IR+M: In the primary market, deals often come to market with new issue concessions, which incentivize investors to purchase them. New issue concessions are particularly common with large, multi-tranche deals, such as the nine tranche, $40 billion deal by CVS — the third biggest US dollar investment grade corporate bond deal on record.

To win over investors, CVS offered a new issue concession to its outstanding debt of 30-40bps during initial price talk; in response to demand, final concessions were 15-25bps. Recently, the new issue concession has averaged about 5bps in 2018, which exceeds that of 2017.

Active managers may be able to take advantage of price dislocations around the new issue market. Occasionally, new or smaller issues may come with an “availability premium,” if these deals are a means for larger managers – or index or exchange-traded funds – to source significant size or diversification.

This is evidenced by little to no, or even negative, new issue concessions. Recently, supply has been heavy, and concessions have been higher than those last year, so we have not seen many negative concessions. Examples of new issues with zero new issue concessions are Concho Resources Inc. and Air Lease Corporation.

Source: Strategic Asset Alliance, Income Research + Management
The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.

1Bloomberg Barclays
The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.