Deutsche Bank: Record high-grade deal flow to ease; floaters popular

By Paul Deckelman

New York, June 19 - Dollar-denominated investment-grade bond issuance is running nearly 15% ahead of last year's record pace - but market-watchers at Deutsche Bank don't believe the primaryside can sustain that kind of velocity over the next six months, predicting that when all is said and done this year's total issuance will come close to 2012's $999 billion of new paper but fall just a little short of that mark.

However, they feel that the market will continue to benefit from the trends seen so far this year, including heavy issuance by financial names, an increasing use of bonds to return money to companies' shareholders or equity sponsors and a growing percentage of debt issued as floating-rate instruments rather than the more common fixed-rate bonds.

Primary volumes race ahead

Issue volumes for U.S. corporate issuers - whether denominated in dollars or, as is the case for a relatively small but growing segment of the market, in euros or in some other currency - "are basically running up 25% year-over year," Mark Fedorcik, co-head of corporate finance for the German banking giant's Americas region, declared. He added that the issuance surge unexpectedly comes against a backdrop of most forecasters having expected supply to be down this year from last year's pace.

"From a volume perspective, obviously the big story this year has just been the degree to which supply has exceeded expectations," said Fedorcik, who is also the global head of leveraged debt capital markets for Deutsche. His remarks came at a press briefing this week during which he and other senior company executives delivered their assessments of how the U.S. investment-grade, high-yield and leverage loan markets were doing at almost the mid-year point.

Those three capital markets "are running at or close to record volumes, from a new-issue perspective. We have a view that it will continue, but maybe not at a record pace like we saw last year. But we are very optimistic on the pace that we've seen," he said.

According to data assembled by Deutsche Bank in connection with the executives' presentations at the briefing, dollar-denominated high-grade issuance, including that of domestic issuers, Yankee bonds issued by foreign-domiciled borrowers tapping the dollar market and the separate and relatively small subset of emerging markets companies hitting the dollar market as well, stood at $490 billion approaching mid-year, ahead of the pace at this time last year.

However, last year's $999 billion record - $140 billion more than 2011's total, topping even the $942 billion recorded in 2006 and the $993 billion issued in 2007 - is unlikely to be broken this year, the Deutsche executives opined.

"Even though we are running a run-rate currently in high grade of up 15% on the year [versus last year], Deutsche Bank estimates currently $960 million [for total 2013 issuance], which is actually a small decline over where we were last year," said Jeanie Genirs, the company's head of global risk syndicate division.

She explained that the second half of the year "is usually quieter than the first half of the year. Last year was very atypical, where the second half was actually busier than the first half - we are not expecting a similar level of activity" this time around. "But coming off a record year , we are going to be in the same Zip code - it will be a very busy year, notwithstanding the last couple of weeks," which have seen reduced activity levels related to the recent back-up in Treasury rates amid investor fears the Federal Reserve may end its quantitative easing program.

Financial borrowers step up

Another factor was a similar trend in issuance first-half/second-half by financial borrowers, such as banks, other mortgage or loan providers and securities broker-dealers, who have become an increasingly important market segment this year.

Marc Fratepietro, the co-head of corporate coverage, capital markets and Treasury solutions for Deutsche, told the briefing that "the growth in [new bond] supply is actually not broad-based across every sector. One of the biggest drivers of supply growth this year" has been the financials, up nearly 30% year-over year. "Almost two-thirds of that growth has come from the big money-center banks and the broker-dealers, which is a basically self-led supply, typically five-years [duration] and in."

Fratepietro said that the suddenly outsized role that the financial issuers have played in this year's high-grade primary activity "is actually a normal phenomenon - it's the market normalizing coming out of the crisis to a large degree. If you went back pre-crisis, banks and financials were always a large part of the market from a volume perspective."

According to Deutsche's data, such financial companies traditionally made up the vast bulk of borrowing in the investment-grade sphere - as much as 81% in 2005 and 78% and 75% in the supercharged issuance levels of 2006 and 2007, respectively. They still accounted for 60% of the borrowings in 2008 - but after the financial market meltdown that began around that time, which included a number of venerable firms sliding down the credit scale into Junkbondland and some, like Bear Stearns Cos. Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. Inc., disappearing as separate entities altogether, the sector's issuance dwindled sharply. It fell to 38% in 2009, and despite stronger years in 2010 and 2011, bottomed at just 29% of the issuance total during 2012's barn-burner of a year.

So far this year, however, the financials' share of overall high-grade borrowing has jumped back, accounting for 47%,versus 45% for non-financial corporate borrowers and 8% for emerging markets issuers. On a run-rate basis, the financials are 30.4% ahead of last year's pace, while the corporates are up just 2.9% and the EM issuers up 21.8%.

However, as is the case with overall high-grade issuance, financial-sector borrowing, Fratepietro said, is generally "front-loaded," with firms traditionally doing most of their borrowing in the first part of the year - "at least 55% to 60% of their issuance [is] in the first half, and the second half is usually down vis-à-vis the first half," he said, making it unlikely that the sector would be the driver for any sustained push to equal or better 2012's full-year issuance totals.

Away from the financials, overall non-EM corporate issuance was running only slightly above last year's pace, although the number is deceptive - volume for the domestic corporates segment was actually up a respectable 10.6% year-over-year, while Yankee bond corporate issuance slid by 21.8% versus year-ago levels. The bank sees this as a reflection of calmer European-currency bond markets this year versus last, as many issuers who did dollar deals last year in response to heightened volatility in Europe returned to their now-stabilized home-country markets to meet their financing needs this year.

Fedorcik said that when analyzing the non-financial corporate issuance, "what you'll see is just two sectors really dominating volume for the year-over-year percentage change - health care and tech," with the latter largely powered by Apple Inc.'s $17 billion behemoth of an offering at the end of April - the largest-ever bond deal.

"That has very much boosted the corporate side of the equation and frankly has made up for the fact that we have had some other sectors, like natural resources and industrials, which have been down [versus last year's issuance]. Other sectors, like media and telecom, which have always been staples of the market, have been flat."

Bonds fund equity payments

Fedorcik said that one of the most interesting developments in the high-grade market - he calls it "the big theme" - has been the growth in the use of proceeds from bond deals to return cash to shareholders and/or equity sponsors by financing share buybacks or the payment of dividends.

"The number of deals and the volume of deals that reference share repurchases in the use of proceeds is almost twice what it was last year," accounting for about 14% of the bond deals done by domestic U.S. issuers and those selling Yankee bonds, he said - "and if you break down the numbers just for U.S. corporates, where the share repurchase trend is much more significant, that number moves to almost 20%."

Fedorcik sees that trend continuing, noting that "share-repurchase announcements this year have been running at levels we haven't seen since '06-'07. There is nearly $250 billion of announced repurchase volume so far this year on the equity side, which will continue to drive the share-repo theme" in the bond market.

But while deals generating proceeds for use in share repurchases or dividends are a definitely up-and-coming market segment, they still pale in terms of the sheer numbers of deals being done in order to refinance existing debt.

"The last two years have been one of the biggest refinancing markets we have seen, given the absolute rates," Fedorcik said - even though the percentage of such refi deals has actually fallen to 36% so far this year from 40% last year.

However, that percentage could pick up as the year plays out, with Fedorcik noting that "the second half tends to be a bigger half for liability management and for people managing their overall maturity profiles. Our expectation is that if rates continue to stay near where they are, you are going to see a pickup" in deals going to fund tenders and redemption calls, and "you may also see a pickup in exchange activity."

In one particular market niche, he said that "hybrid issuance out of the financial space, principally bank preferreds, has almost doubled from the first half of last year to the first half of this year, being very much driven by a trend of banks refinancing trust preferreds and the attractive level of rates. We expect this trend to continue."

He noted that the market has "still north of $37 billion of trust preferreds out there that could be refinanced. Not all of them are good call candidates, but I think one could expect that - again, subject to market appetite for those securities - you'll see a healthy amount of hybrid issuance," much of it for refinancing existing trust preferreds.

Floaters a growing presence

Genirs meantime observed the sharp increase so far this year in issuance of floating-rate notes rather than traditional fixed-rate bonds.

"In 2012, only 3% of that record volume of $1 trillion was floating, totaling $32 billion. In 2013, we've already had almost double that nominal number, $62 billion in floating."

She attributed the rise partly to the increased issuance out of the financial sector, where floaters have always been a mainstay, but said that "probably more importantly, it's a little bit more of a defensive posturing from investors as they begin to worry - even earlier this year - about higher [interest ] rates. What's the best defense around that? Take a little bit more floating-rate exposure. That's been a major trend that we've seen, even before this recent rate movement, and one that we expect to continue for the near-term."

Genirs explained that typically, "our credit investors aren't very long Treasury securities, so when high-grade credit funds have to manage their duration, they have to sell credit bonds. If we have rates gapping higher in a somewhat unstable fashion, it can be difficult for portfolios to liquidate some of their holdings in an efficient manner. So one protection against both higher expected interest rates and market illiquidity is to have a bigger percentage of their portfolios in floating-rate notes, so that if rates start to back up, hopefully they're capturing the benefit of higher rates as opposed to being hurt by it."

Floaters, she continued "are very much a shorter-duration instrument, because the coupons are typically re-set quarterly. So, if rates are moving higher, the floating-rate coupon resets will capture that backup in rate action to their advantage."

Fedorcik said this increased investor appetite for floaters, in turn, is encouraging issuers to include them in many of the new bond deals coming to market.

"From an issuer perspective, the dynamic around floaters is them responding to investor demand for the product - there are investors who, because of the potential for the rise in rates and the carry dynamics around them, want to own floaters right now. While a lot of issuers would rather be more fixed, they see the demand for floaters. If they are trying to get a deal done for a particular size, they can get a bigger book if they include a floater."

Genirs opined that "the key word here is 'responsive' - when we bring an issue to market, we'll often use the language 'fixed and/or floating,' so that we have the most flexibility to both listen and respond to exactly what investors want."

However, she concluded, "I would say, though, that this trend has been so strong this year that even if we don't say 'fixed and/or/floating' and announce just a single fixed-rate tranche, there's a very good chance that we'll receive multiple incoming calls from investors saying 'can you add a floating-rate tranche to this transaction?'"

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