Outlook 2023: High-grade bond market braces for lower deal supply, tighter credit spreads

By Cristal Cody

Tupelo, Miss., Dec. 30 – The high-grade bond market saw new normals in 2022 – record losses, a record number of no-print days, a wave of dropped floating-rate tranches as interest rates soared and overall lower issuance.

Volume declined by about $300 billion to approximately $1.2 trillion in 2022, in line with forecasts.

Corporate and sovereign, supranational and agency issuance through November totals about $1.29 trillion, down from $1.44 trillion a year earlier, Prospect News data shows.

The year was “defined, of course, by extreme volatility,” said Ronald M. Quigley, head of fixed income syndicate, primary sales and FIG/utilities DCM at Mischler Financial Group, Inc.

“We trailed 2022 IG Corp issuance by 19.7%,” or $1.198 trillion in total investment-grade corporate issuance in 2022 versus $1.492 trillion in 2021, Quigley said.

December was shaping up to finish with less than $8 billion of high-grade issuance for the month, short of market forecasts of about $25 billion of volume.

The month and year were set to end with the last high-grade deal priced from JPMorgan Chase & Co., which brought a $3 billion three-year note on Dec. 12. The 5.546% notes due 2025 (A1/A-) priced 15 basis points tighter than guidance at a spread of Treasuries plus 115 bps and later firmed 2 bps in the secondary market, sources said.

The investment-grade market is bracing for lower volume in 2023.

High-grade issuance is expected to decline to $1.15 trillion in 2023 from $1.2 trillion in 2022, BofA Securities analysts forecast.

Supply is expected “to slow on even higher debt costs in 2023, some moderation in bank supply and lower M&A borrowing needs,” according to BofA. “Offsetting that should be a potential backlog from the second half of this year and stronger investor demand.”

Strong supply start

Appetite for high-grade bonds is expected to stay strong, especially in the first two months of 2023, sources report.

January is anticipated to shift into high gear quickly with about $130 billion to as much as $150 billion of supply, syndicate sources said.

“January/February should be robust as usual,” said Quigley, who noted the past three-year average for January volume is $136.34 billion.

January SSA issuance has averaged $58.72 billion across the last three years, he added.

Also, deal volume in the first month of the year “tends to be dominated by financials that have had a much stronger supply momentum this year compared to corporates,” according to BofA.

“We do not expect the weak late-2022 pace of supply to persist into 2023 for two reasons,” BofA said. “First, the unfavorable market conditions likely delayed issuance and pushed it instead into 2023. Second, we look for better demand in 2023 as we get more clarity on the Fed and more stable yields. That's why we expect the even higher borrowing costs in 2023 to have a much more benign $50 bn impact on supply next year.”

However, the view gets murkier in the spring.

“Despite expectations for a busy January/February of new issuance, all eyes are firmly on March and April,” Quigley said. “Those are two very critical months re: inflation, interest rates, Fed and central bank maneuvers. Finance Ministers pin-pointing that period as critical. I think we're headed for a bumpy year ahead.”

Economy hits volume

The New York Federal Reserve reported Nov. 25 in its weekly Corporate Bond Market Distress Index, launched in 2022 that market functioning “appears healthy” but “somewhat more strained in the investment-grade segment.”

The Federal Reserve raised the target range for the Federal Funds rate by 50 bps to 4.25% to 4.5% at the December meeting in hopes of taming inflation to 2% over the longer run.

BNP Paribas Markets said it expects the Fed to follow December’s hike with a 50 bps increase in February and a 25 bps hike in March, “at which point we see it holding Fed Funds at 5.25% through the balance of next year.”

According to S&P Global Ratings’ U.S. chief economist, Beth Ann Bovino, the dollar forecast is high and weighing on U.S. production.

“We see the dollar working rather strong through 2023,” she said. “We see an incredible move to flight to safety which doesn’t seem to be changing anytime soon.”

Federal Reserve chairman Jerome Powell, in the press conference following the Federal Reserve’s rate hike decision in December, was clear there was little chance of a rate cut in 2023.

Powell said he “wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way. There are not rate cuts in the SEP [Summary of Economic Projections] for 2023.”

Capital market conditions are likely to remain volatile as a result of rising interest rates, uncertainty regarding the severity of the recession and the downward trajectory in corporate earnings, Fitch Ratings said.

“The global macroeconomic slowdown will be a headwind for North American investment-grade corporates in 2023, but the overall credit outlook for credit conditions is neutral,” Fitch said. “Still, investment-grade bond issuance could improve, given upcoming maturities and the potential for strategic M&A in some sectors.”

M&A supply slows

The mergers and acquisition space saw some bumps in 2022.

“It’s no longer a sure thing if you announce a deal, it’s going to close,” JPMorgan’s global chairman of investment banking and mergers and acquisitions, Chris Ventresca, said in an M&A conference hosted by S&P in December. “Deals are taking longer. It took the average deal account to close like 3½ months. Now, it’s 4½ months, and there’s a long list of deals that take over a year to close, and some go over a year and they don’t close.”

In November, DuPont de Nemours Inc. backed out of a $5.2 billion acquisition of Rogers Corp. (Baa1/BBB+) that had been pegged for potential high-grade funding needs.

DuPont announced it pulled out of the deal due to regulatory clearance hurdles after reporting in September that it had received all regulatory approvals except from China. DuPont will pay a $162.5 million termination fee to Rogers.

“2022 was the second slowest year for M&A-related IG financings since 2015,” Quigley noted. “2020 had only $93.25b in M&A deals, but that was the pandemic year.”

In 2022, only 482 deals closed versus 675 in 2021, according to Christine Short of Wall Street Horizon, Inc., which was acquired by Toronto Stock Exchange operator TMX Group Ltd. in November.

2022 did see an uptick in spinoffs with 32 significant spinoffs, the highest since 2016 and beating the five-year average of 29, Short said.

Most of the year’s deals were smaller than 2021’s heavyweight bond sales, such as Verizon Communications Inc.’s $25 billion eight-tranche offering, AerCap Ireland Capital DAC’s and AerCap Global Aviation Trust’s $21 billion nine-tranche offering, Amazon.com, Inc.’s $18.5 billion eight-part offering and Oracle Corp.’s $15 billion six-part issuance.

One issuer did bring an even larger offering from the M&A space in 2022, while Amazon.com and Oracle both were back in the primary market with smaller deals.

Discovery, Inc. priced $30 billion of senior notes (Baa3/BBB-/BBB-) in 11 tranches from Magallanes, Inc., a wholly owned subsidiary of AT&T Inc., on March 9 to fund a joint venture with AT&T and Discovery. The notes were offered in connection with the combination of Discovery and the WarnerMedia segment of AT&T in a Reverse Morris Trust-type transaction.

Oracle finally priced its long-awaited bond offering on Nov. 7 after closing in June on its $28.3 billion acquisition of Cerner Corp., but with a size much lower than the double-digit deal expected in the first half of 2022.

The company sold $7 billion of notes (Baa2/BBB) in four tranches that priced tighter than talk by 35 bps to as much as 55 bps on the 30-year tranche, a source said.

Of the top 10 M&A deals in the third quarter, only three reached double digits, while all top 10 global deals in the second quarter and eight of the top 10 deals in the first quarter were above $10 billion, S&P said.

The aggregate deal value for the quarter was $443 billion, down 50% compared to the second quarter and a 58% drop from third quarter of 2021, S&P said.

“There’s a lot of uncertainty in the market right now,” James Socas, managing director of tactical opportunities at Blackstone, said at the S&P M&A conference. “We’re cautious on looking at things right now – the war in Ukraine, Fed issues, there’s a lot of variables. Right now, private equity valuations tend to lag public value valuation.”

M&A-related high-grade bond supply is expected to remain mostly unchanged to slower in 2023.

“The current pipeline of announced M&A deals with potential funding needs in the IG corporate market implies a run-rate of M&A-related supply of about $120bn over the next 8 months – similar to the pace so far this year,” BofA analysts said. “However, slower economic growth and uncertainties should weigh on M&A volumes going forward. In fact, M&A activity has already slowed down over the past few months compared to the elevated pace in 1H-2022. That should reduce the pipeline in the second half of 2023, resulting in lower M&A funding needs in our market.”

Fewer 2023 deals

There is a “general expectation that market and operating conditions will likely be more difficult for issuers in 2023,” S&P said in a December report. “As for IG, despite higher corporate bond maturities next year, we expect lower issuances driven by high borrowing costs, less M&A funding needs and a slowdown in bank supply.”

S&P said that globally, including China, across the “83 banking systems that we cover, we expect credit losses will amount to around $2.1 trillion over the three years to end-2024.”

A modest drop in bank supply is on deck for 2023 following two years of strong volume.

“Heavy bank supply in 2021 and so far this year has been running well ahead of maturities, pushing index debt up about 10% YoY for both U.S. and Yankee banks by the end of October,” according to BofA. “That is likely not sustainable, and we in fact have already seen a slowdown in bank supply in the last couple of months, and particularly for the big six U.S. banks and brokers.”

In addition, U.S. bank spreads were near their cheapest levels since 2013 in 2022.

The U.S. bank sector “is trading quite cheap right now,” BofA’s head of investment-grade credit strategy, Yuri Seliger, said in December. “Non-financial supply is down something like 30% in 2022, financial supply is unchanged this year. We’ve had a lot more issuance, including from banks, than a lot of investors expected.”

Floating-rate debt drops

Issuers got comfortable with near constant volatility in 2022 as Russia kicked off its war against Ukraine.

In May, usually a heavy supply month, several companies stood down due to unfavorable market conditions.

By July, the cracks were starting to show with issuers staying to the sidelines and existing high-grade paper under pressure. Notes from investment-grade issuers including Oracle and Amazon.com were trading on handles in the 60s to low 80s, a source said.

The year saw a record number of sessions where all investment-grade issuers stood down in the primary market.

2022 saw a total of 48 non-Friday, non-holiday shut-outs, Quigley reported.

“The previous high was 33 in 2008,” he said. “An exorbitant amount of no-print sessions by any measure.”

The year also saw the case of the abandoned floater.

Soaring interest rates cut into the popularity of floating-rate notes, usually offered with a matching fixed-rate tranche.

“Year-to-date our IG dollar DCM has witnessed a total of 56 dropped FRN tranches during book builds,” Quigley said. “By comparison, that’s two more than the past three years combined (54). In 2021, 17 FRNs were dropped; 2020 featured 24 FRNs that didn’t make it to pricing and in 2019, 13 were left to vaporize before the launch. Pretty interesting.”

Issuers that dropped floating-rate tranches in 2022 included Morgan Stanley in October when it sold $6.5 billion of notes in three parts and dropped a four-year floater.

In September, Bank of Montreal dropped a floater from its final $2.5 billion two-part deal.

In August, Credit Suisse AG, New York Branch eliminated a tranche of floaters from its final $2.5 billion two-part senior note offering.

The trend continued as late as Nov. 30 with Bank of Nova Scotia dropping a matching floating-rate tranche from its final deal when it sold $1 billion of 5.25% fixed-rate notes due 2024 (A3/A-/AA-) at a 90 bps over Treasuries spread, a source said. Talk was at the Treasuries plus 110 bps area.

Market pressure remained heady in 2022 with “higher borrowing costs for lower-rated credits, particularly those with floating-rate debt,” noted S&P’s Bovino. “Speculative-grade, consumer products, high tech – that’s where we’re starting to see already some of the pain.”

Firm IG spreads in store

More than $300 billion of liquid investment-grade bonds from names including Apple Inc., Google Inc., Amazon.com, Microsoft Corp., Berkshire Hathaway Energy Co., JPMorgan Chase, Merck & Co. and Verizon Communications were trading at dollar prices below 75 points back in the summer.

In November, Credit Suisse Group AG priced $2 billion of 10-year notes (Baa2/BBB) with a 9.016% coupon and a spread of Treasuries plus 485 bps, tighter than talk in the 512.5 bps spread area, a source said.

Credit Suisse brought the notes to the market as the issuer got underway with a restructuring of its investment bank.

Investment-grade spreads have widened off 2021’s stimulus-fueled lows, but by year’s end remained inside the average of the 10-year period after the global financial crisis and before the pandemic, KBRA said in December. “Moreover, we’re 30 basis points inside the recent wides set in October.”

KBRA attributes spreads holding in to factors including that high-grade yields of around 6% attracted healthy bids and lower deal volume.

“After drinking from the proverbial firehose of new issues in the federally backstopped credit market of 2020-21, investors are now facing supply that is materially lower due to the issuance pull forward we saw in those years, as well as today’s rapidly decelerating growth forecast,” KBRA said. “All of a sudden, supply could actually be characterized in some ways as ‘scarce,’ or at least more normal. We still believe the gravitational pull for spreads is wider into 2023 as the economic contraction becomes more evident, but we expect a mild recession that should keep spreads inside of past recessionary peaks.”

Just to be clear – the expected investment-grade default rate for 2023 is “zero,” according to BofA Securities.

“Given attractive yields, but a potential recession next year, we are often asked about the expected default rate for IG,” BofA said.

“The answer is that in a typical year no IG defaults occur, and we think that is likely the case for 2023 as well,” BofA said. “When they do happen, defaults tend to be idiosyncratic driven by events like fraud (Enron, WorldCom), the financial crisis (Lehman) or climate change (PG&E). IG defaults have averaged 0.08% per year since 1970.”

Despite all the volatility and a potential recession in 2023, the “IG credit markets show little signs of pricing any credit stress,” BofA noted. “All our indicators show either minimal or typical signs of credit stress, including spread dispersion, lower credit quality relative value, ratings momentum, and market pricing of potential downgrades to high yield.”

High-grade spreads are targeted at 130 bps in 2023 on the ICE BofA US IG corporate index, tighter than the 145 bps the index posted in December.

Bond dollar prices are expected to matter less.

“Bonds trading at very low dollar prices have been popular with investors this year and had a positive impact on spreads,” Seliger reported. “In 2023, the impact of dollar prices should diminish on a combination of both lower interest rates and tighter spreads.”

Back-end BBB spreads should be most impacted by higher dollar prices in 2023, according to BofA.

Ten-year spreads are expected to normalize tighter in 2023 as outflows from bond funds end.

More inflows

Mutual fund flows “should switch from big and consistent outflows in 2022 to inflows in 2023,” Seliger said.

“We think the big driver of this cheapening of spreads has been big outflows,” he said. “We had big outflows this year. We are looking for flows to turn positive in 2023. Flows tend to follow returns with about a month lag. We see outflows stopping pretty soon.”

Stronger demand should support supply of $1.15 trillion in 2023, he said.

High-grade returns are expected to flip from some of the highest losses on record at 17% through early December to strong gains of 13% in 2023, Seliger said.

“Even if returns are lower than our expectations, bonds are unlikely to deliver such record losses next year, suggesting a much better flows outlook starting in December 2022,” he said.

U.S. high-grade funds and ETFs saw a $1.14 billion inflow over the week ended Dec. 14 that followed a $1.21 billion outflow in the prior week, according to a BofA research note.

Corporate investment-grade funds were headed toward the year’s end with about $125 billion of annual outflows, a source said.

High-grade corporate investment funds inflows declined to $177 million in the week ended Dec. 14 from $1.2 billion of inflows in the previous week after heavy outflows of $6.92 billion in the week prior, according to Refinitiv Lipper US Fund Flows.

Libor transition

A few other issues also are circulating in the backdrop of the high-grade bond market and expected to make an impact in mid-2023 and 2024.

The official replacement from Libor takes effect in 2023.

The Federal Reserve Board announced in December that it adopted the final rule that implements the Adjustable Interest Rate (LIBOR) Act by identifying benchmark rates based on SOFR that will replace Libor after June 30, 2023.

The board said Libor was the dominant benchmark rate used for decades, but “it was fragile and subject to manipulation.”

Meanwhile, plans started taking shape in 2022 to shorten the bond deal settlement period – from two days to one day by 2024, according to Sifma.

Before 1975, the settlement cycle for bonds was five days after the trade. The period was shortened to three days by 1993 and then two days in 2017.

“Following the industry’s successful work to transition from T+3 to T+2 in 2017, Sifma, the Investment Company Institute, and the Depository Trust & Clearing Corp. are now collaborating to accelerate the U.S. securities settlement cycle from T+2 to T+1, which should be completed in the third quarter of 2024, pending regulatory support,” Sifma reported in December.

The shorter time will mitigate settlement risk, Sifma said, but will require major changes to impacted areas, including in global settlements, documentation, securities lending and clearinghouse processes.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.