A new deal?
With many companies now moving to reduce the debt they issue against an uncertain market backdrop. Insight Investment portfolio manager Gautam Khanna explains why this is happening and what it might mean for bond investors.
Q: Can you describe why companies are issuing less debt than they were at the onset of the pandemic and how does it affect the wider fixed income universe?
A: Issuance swelled to record volumes in the months after the pandemic hit in March and April. This was a result of issuers coming to market to exercise the ‘precautionary principle’. They raised liquidity and termed out debt to ensure they had enough cash to ride out an extended period of uncertainty. The reason issuance has since dropped off is because, quite simply, most of this activity has been completed. The bulk of large investment grade corporates now have the liquidity they need and have little need to return to the primary market.
As such, we expect issuance to continue to slow down in 2021 – with perhaps 25% to 35% less issuance next year. This could benefit some investors, from both a technical and fundamental perspective. From a technical standpoint, falling supply means that prices will rise (all else being equal). And fundamentally, a company’s liquidity position is one of the most important metrics for their ability to repay debt.
With a clearer outlook, companies may increasingly find themselves in a position to normalise their liquidity positions, taking out debt via tenders and exchanges.
Q: Where are some of the areas you’re seeing this most prominently take place?
A: Since the pandemic hit last March and April, the first issuers to come to market were typically the largest and most robust investment grade corporates, or credits from ‘stay-at-home’ sectors that were in a position to benefit during the pandemic (such as technology, telecommunications and supermarkets). By contrast, the last to arrive were typically smaller names, high yield companies and those with business models that were particularly exposed to a stay-at-home world (such as theme parks, cruise liners or energy companies). Generally, it’s these names that still need to issue. Within the ‘winning’ sectors – there may be opportunities to move down the capital structure of individual issuers or perhaps into more niche players.
The ‘losing’ sectors may also offer potential opportunity as long as they have sufficient liquidity, staying power and best-in-class credentials. Many have a potentially compelling path to recovery as vaccines get rolled out and life normalises. Those names may also benefit from reduced competition, as their weaker peers fade away, as well as the ability to consolidate their market share or consolidate through acquisitions.
Q: Do you anticipate smaller deals and fewer new higher-rated debt deals in aggregate?
A: Some smaller companies and lower-rated names still need to come to market. However, the exception may be mergers and acquisition (M&A)-related issuance. As corporate boardrooms at the largest and stronger companies gain more confidence about the future, we’ve noticed they are starting to raise debt to acquire smaller competitors, in an effort to consolidate their position and structurally engineer shareholder growth. For example, in the energy sector, some smaller players have merged to generate better economies of scale and reduce production costs.
Because M&A activity can be unfriendly to bondholders, as it is associated with rising leverage, it can also be a credit positive event for lower-rated acquisition targets. For example, if a high yield issuer is acquired by a large investment grade company, the high yield bondholders might be expected to benefit. This may provide opportunities to investors who can avoid companies with an appetite for leveraged acquisitions but who consider adding those likely to be the targets.
Q: Can you comment on the importance of security selection moving forward?
A: We believe security selection will continue to be crucial for investors because—while the path of the pandemic may now be clearer—it sharply sped up a number of secular trends.
In our view, the pandemic may have permanently accelerated changes to how people work and may be a game-changer for productivity growth. It also likely accelerated the process of creative destruction; thus, the ability of policy makers to manage the transition from the old regime to the new one will be crucial. Unfortunately, it feels likely there will be some bumps in the road along the way. There is a need for investors to be particularly careful during periods of regime change. This is because the disruption could be painful for certain areas that are now well into secular as well as cyclical decline, such as retail and potentially some areas of commercial real estate, though this disruption may be positive for a number of industries.