Selection now a key factor in corporate debt

A tighter concentration of investment-grade corporate debt this year is forcing institutional investors to become more selective when seeking debt for their portfolios.

So far in 2016, investment-grade issuance is running 9% above 2015 levels. But 31% of the $230 billion in investment-grade corporate debt issued as of March 1 came from three companies: Apple Inc., Anheuser-Busch InBev SA/NV and Exxon Mobil Corp.

“Selection has become more important over the last year. The idea of blindly allocating to credit is no longer the case,” said Jeff Cucunato, managing director and head of U.S. investment-grade credit at BlackRock Inc., New York.

“For investors that have the ability to be providers of liquidity, this presents an opportunity,” he added.

According to Bryon J. Willy, a principal at Mercer LLC in Chicago, the issue for investors is that the volume composition has changed, with less block-trade volume and smaller trades. This means larger managers have been forced to split trades into smaller pieces.

“More recently issued bonds by large issuers are most likely to trade in block size, and therefore, are more liquid,” said Mr. Willy, noting this means a couple of things for managers.

The first, is that a buy-and-hold or buy-and-maintain portfolio will become less liquid through time as a result of bonds rolling down the maturity curve.

The second is that large managers with daily flows and/or higher liquidity needs will have to consistently switch into recently issued securities to remain more liquid, which implies incurring more transaction costs.

“Right now, the differential between liquid and illiquid securities has increased — this premium is generally correlated with credit market spread levels and volatility,” Mr. Willy added. “So this is an opportunity for managers willing to take on less liquid securities.”

J.R. Rieger, global head of fixed income at S&P Dow Jones Indices, New York, agreed that the securities from the bigger issuers of corporate debt have more liquidity.

“They enjoy better depth of liquidity than the smaller issuers and that's where the dichotomy in the market is,” Mr. Rieger said.

He said that this dichotomy could create an opportunity for investors “because there'll be a liquidity premium associated with those bonds” from “smaller financial entities.”

“Those yields should be cheaper as a result of less liquidity in the market,” he said. “The smaller entities may have to pay higher yield. This could help institutions be selective in what they want to add to their portfolio.”

Asset owners interviewed for this story seemed unconcerned with the high concentration in issuance of investment-grade debt.

“We have noticed a few slow periods of new issuance, but this comes as no surprise that there may be a pause on a particularly volatile day and certainly prior to a big Fed announcement,” said John Kuczwanski, communications manager with the Florida State Board of Administration, Tallahassee. “It sometimes appears a bit choppy around earnings season.”

Meanwhile, Ricardo Duran, spokesman for the $179.4 billion California State Teachers' Retirement System, West Sacramento, said the plan doesn't believe there's a problem with concentration in the issuance of investment-grade debt at this time.

“We expect the supply to continue. Despite the spread widening, all-in financing costs for investment-grade issuers are static as U.S. Treasury yields have offset the upward movement in spreads,” he said.

He noted CalSTRS officials believe that supply will continue in March as maturing debt needs to be refinanced and M&A deals need funding.

Mr. Duran added that CalSTRS executives also see “no particular source of opportunity in the current investment-grade issuance pattern except among new-issue companies, where we see good relative value at an attractive concession.”

BlackRock's Mr. Cucunato explained that the increased concentration is a sign bond markets are becoming more selective, reflecting macro uncertainty.

“I think the market is quite open for some issuers that are perceived as high quality,” he said.

He added, however, that it does signal the market could be a challenge for companies that are cash-flow challenged.

Mr. Cucunato said he expects to see more story issuers try to access the market and to seecommodities-related companies fare better than currently.

“I expect that we're going to see $120 billion of new issues (in March), if not more. It depends on the market,” he said.

Ryan Brist, portfolio manager and head of investment-grade credit at Western Asset Management Co., Pasadena, Calif., argued that the current environment where corporate issuers have to borrow money with a larger spread premium relative to prior years “presents an attractive opportunity for long-term, fundamental-value-based investors.”

Added Mr. Brist: “Anheuser-Busch InBev's acquisition of SABMiller was a solid fundamental deal. Apple, in contrast, borrowed money to increase shareholder returns. Yet, both large bond deals were well received by the marketplace despite a challenging macro backdrop.”

Meanwhile, Mark Kiesel, Pacific Investment Management Co.'s chief investment officer for global credit, Newport Beach, Calif., said he sees the corporate bond supply concentration as a good thing, because it signals the credit markets are differentiating.

“We've gone through a period where lending standards were too open. You need more diligence and analysis. The markets are becoming more discerning and careful, and I think that's very healthy,” he said.

Mr. Kiesel added he believes corporate bonds can deliver 4% to 8% returns with half the volatility of equities. “I actually think that's conservative,” he said.