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Interest rates increased rapidly to combat inflation in North America in the first half of 2023. However, the U.S. Federal Reserve Board and the Bank of Canada may be nearing the end of their robust monetary tightening cycles. Could this help promote market sentiment and stability?
On this episode of Market Points, you’ll hear insights from Patrick Dabiet, Managing Director and Head of Canadian Debt Syndication and Fadi Attia, Managing Director and Head, U.S. Debt Syndication. They’ll look back at corporate bond issuance patterns in the Canadian and U.S. markets in the first half of 2023. They’ll also look ahead to highlight key areas for borrowers and investors to consider during the rest of the year.
Let's get started. Here’s Patrick Dabiet.
PD: Fadi, thanks for joining me today.
FA: My pleasure. Definitely a lot has been going on. So where shall we start?
PD: Well, why don’t we get started in looking back at the first half of how 2023 played out and thinking about Canada, first and foremost. I would characterize the first half of the year as being constructive and positive, despite some headwinds and challenges that the market, broadly speaking, was facing. We saw green shoots developing in those first 1 to 2 months of the year before problems with Silicon Valley Bank sprung up. I would say we also experienced a more aggressive hiking cycle that led to a decline in global expectations for interest rate cuts, or when you think about January of this past year, we were anticipating cuts as early as July. Ultimately, where we stand right now, that's been pushed back to 2024. And if that materializes, remains a key question mark. From a supply perspective, I would say was broadly in line with what we were expecting, maybe a touch on the lighter side. But I think more importantly, that mix and proportion between corporate and financial borrowers reverted back to what we were accustomed to seeing pre-pandemic, which was roughly 40% corporates. But maybe over to you on the US side. How did you see the first six months of the year play out?
FA: The credit market in the US was pretty active during the first half of 2023. We're tracking about 5% below the same period last year. For me, the key word is resilience. Our market was fairly resilient in the face of the banking headwinds combined with the aggressive Fed hiking cycle. We did endure a material sell off in mid-March on the back of the U.S. regional bank concerns, but it didn't really take that long for the market to bounce back and recovered pretty much most of the weakness going into June and July. Just to give you a bit of context, the corporate index traded as wide as 163 basis points on March 15th and then quickly recovered to 132 basis points about a month later. And then we managed to claw back another ten basis points of recovery as we closed out the first half of 2023, at best spread of 122. Corporate borrowers were particularly active during the first half. Lion's share of issuances accounted for by the corporate issuers 60% of that volume, which is well above the 50% that we typically see on average over the past three years. The key driver there was really sensitivity to this rising rate environment, plus the spike in volatility that issuers had to endure, which helped support that uptick in new issues. Similar to Canada, banks from a funding perspective were a lot lighter. I think that was a direct result of heightened level funding that took place in 2022 and the first half of 2023 ended up with 35% less financial to access that market versus the same period last year. We have seen issuers increasingly turn to reopenings for funding flexibility. That's increasing the existing size of benchmark transactions, which was 27 different deals executed during the first six months of 2023. That's compared to 12 for the entirety of 2022. Interestingly, floating rate notes did remain muted, and that's despite the rising rate environment. Very limited number of deals actually ended up being priced in floating rate, no format. And that was a function of the lack of demand from the investor side relative to fixed rate products. And then finally, M&A funded deals were pretty visible, 12% of issuance for us during the first half of 2023. As more power stepped into the significant amount of liquidity the investors provided to allow for issuers and de-risk these deals.
PD: Right, so we've looked at some of the numbers that characterized the first half of the year. But let's dive a little bit deeper into how borrowers have been adapting to market conditions.
FA: Yes, let's do that.
PD: From a borrowing lens perspective, the 2022 story was issuers adjusting to the new normal, and that kept a significant proportion of borrowers out of the market entirely. This year I would say we saw more borrowers come forward in the first half of 2023, but I think ultimately there's still a significant portion of those borrowers still remaining on the sidelines hoping to catch that wave of lower interest rates. Now, whether or not that is going to actually materialize so far, I think that has still been an evolving story. But to your point about financial institutions, I still think that we are still recovering from the issuance that we saw last year. Also, as well as a lot of those capital products that were reprice post, Silicon Valley Bank and Credit Suisse, those are now normalizing to quote on quote, levels that we saw prevailing through the course of last year. So I think that that is something that we will be looking for in the second half of the year to see if we do see a little bit of incremental funding from the financial institutions. But our expectation is they're going to remain relatively quiet for the second half of the year. That's how things played out in Canada. How have issuers in the U.S. been adjusting?
FA: I would say the rising cost of borrowing and the heavily inverted U.S. Treasury curves has definitely complicated the funding mix for most borrowers. But in particular the corporate sector. We've had some issuers who preferred to avoid the long end of the curve because they were concerned about locking in these higher than average coupons versus their historic funding levels. This group of borrowers have preferred to fund their needs in the front end of the curve. So two years to five years. Some other borrowers did see value in going longer and they based that judgment on the basis of the lower extension costs in terms of debt. To offset the negative carry, which means basically borrowers funding before deploying the proceeds that they need, these borrowers have been able to benefit from earning a higher interest rate on the cash that they borrowed by investing these proceeds in short dated risk free instruments or depositing this cash with highly rated financial institutions. As market volatility remained a risk to execution, issuers have been proactive in engaging and mandating syndicate groups earlier. To allow themselves more flexibility in picking appropriate execution windows. That's been a critical strategy that has worked well for a good group of issuers. We've also witnessed an increase in rate hedging the day of or leading into a new issue before it gets announced to the market to offset some of this intraday volatility as order books came together.
PD: So based on all of that activity from the issuer side, I think it's important to get the other side of the equation, which is how investors have been responding to the volatility in the market conditions that they've been seeing. So what have you been seeing on your side in the U.S. investor base?
FA: Healthy conditions on the investor side. Credit investors continue to see consistent inflows during the first half of the year, and that helped to bolster the liquidity and the cash available for them to invest and allowed issuers deeper market access as they contemplate funding. The allocation of funds towards fixed income within Multi-Strategy accounts remain pretty well anchored, just given the higher returns that many of these accounts are able to achieve by investing in fixed income versus other risk assets like equities. The progressive move tighter and credit spreads and spreads, meaning the difference between the bond yield and the matching government bond yield, coupled with the contained interest rate volatility and that's obviously the relative to 2022 did help deliver better returns on investments this year for the investment grade asset class. The returns this year have been 3.5%, and you compare that to the full year, 2020 was -0.5%. So we've witnessed at some point a more defensive investor approach towards bank issuers, but that was primarily around the March period after the Silicon Valley situation transpired. That ended up delivering wider spreads for the bank space. But as we’ve discussed, the lack of issuance by banks certainly helps offset some of this dynamic. And the snapback in levels during June, as showcased at Investor confidence improved towards banks and remained very much supported by a market backdrop that has become more conducive. The new issue market conditions continue to drive the lion's share of investors investment focus. Because the secondary market just continues to be much more challenging in terms of deploying sizable demand efficiently. We've seen investors try to solve for that by being proactive with providing reverses, which are effectively unsolicited orders for new issues that increase throughout the year. We expect that to continue to be an effective way for investors to aggregate assets, and it also helps give issuers more confidence in de-risking new issues. As valuations continue to be attractive in fixed income, couple that with higher returns, we expect this to anchor an outsized level of cash in our market and benefit issuers as they refinance upcoming maturities or even fund M&A activity as it picks up.
PD: Yeah, so I think a lot of the same themes that you highlighted we saw as well here in Canada and I would say the year began with a very constructive outlook for the asset class, for fixed income specifically. And when you compare what 2022 ended up being, which was the worst year for returns on record, I think the thinking was, ‘How much worse could it get?’ On the one side. On the second side of things, you saw yields that had not been seen really since before the financial crisis. And so that was setting up the asset class for, I think, a constructive start to the year. Ultimately volatility, whether it be from Silicon Valley Bank, Credit Suisse interest rate outlooks, etc., did at some point or another challenge the investors perception of credit. However, I would say to your point, certainly the yield on offer and I think some of the elevated spreads that we'd been seeing did bring investors back to the table. And we've been seeing more and more engagement as we've made our way through the months of June and into the summer. So from that perspective, I think the asset class and investor base specifically have felt fairly resilient to everything that they've been dealing with and I think hopefully sets us up well for an active and busy second half of the year.
FA: Well thanks for painting the picture for borrowers in Canada, Patrick. Let's take a look at a critical aspect that could shape our market conditions as we head into the second half of 2023. And that's supply outlook, how is that shaping up in Canada?
PD: Yeah. And so it's been again a relatively active first half of the year. We have recut our supply forecast and we're looking for somewhere between $105 and $110 billion on the year. That's around $10 billion lower than our January estimate. But I think when you think about that total amount that we're expecting, it's still a very respectable number, especially when you think about it from a pre-COVID perspective, where $100 to $110 billion would be the sort of going range. So we are anticipating the yearly total to be a very respectable number at the end of the day. That being said, I think the first half is proving to be relatively busy. Most notable is the fact that the calendar is becoming increasingly challenging to navigate for borrowers. So, while we might anticipate some supply to come through when and how it comes through the market still remains to be seen. I think we’re still anticipating financials to be relatively slower from a supply pace perspective, and that's again a function of where rates are, the shape of the interest rate curve right now. And on the corporate side, we're expecting a fairly broad-based amount of issuance when you think about the sectors that are typically represented. So we're anticipating no one sector to be overly represented versus others, which I think is constructive for a very healthy market. At the end of the day. What are you seeing on your side, Fadi?
FA: Well we expect the second half of the year to be pretty active, primarily driven by corporate refinancing, upcoming maturities and funding for additional leads. In the financial space we expect the banks to become relatively more active than the first half as they anticipate additional funding and capital, which is likely to be introduced by their respective regulators across the globe. Our expectation remains the same for the total new issue supply for the year at $1.25 trillion, which remains in line with our forecast as we set it in January of this year. You know, despite the favourable market tone that kicked off in the second half of the year so far, we do expect short-lived headwinds to emerge as the market continues to adapt to new macro paradigm and get more consistent assessment of the US economy. ESG has been a critical piece developing in our market as it has been globally, but new issues did slow down dramatically there, 50% drop in the first half of the year versus the same period last year. But we did see variation within sectors. Utility sector is expected to continue to lead the transition trend in the U.S., particularly with labeled bonds, green bonds. We expect the increase in buying in the second half of 2023, which will carry over into next year. Investors certainly remain pretty focused on investing in ESG, but has become much more sensitive to ensuring that issuers are using robust, verifiable frameworks and much more less willing to give up, spread or return given the elevated market volatility overall.
PD: So let's turn some attention to what we're looking out for in the second half of 2023. How do you think borrowers should approach the market in light of everything that we've laid out?
FA: We expect to see a more consistent trajectory on the economic data front that should help clarify the narrative around the magnitude of any recession if it were to materialize here in the US. Now, with the majority of the interest rate hiking cycle in the U.S. and globally for that matter, are mostly behind us, we do expect this to help anchor volatility at current levels, which could be conducive for new issue environment. But we would err on the side of caution as far as taking the recent improvement in the market down for granted, we think issuers would benefit from remaining nimble in anticipating their funding needs while in advance and be flexible around the selection of tenors and structures. We are seeing divergence in market conditions, funding levels around the globe which can create opportunities for borrowers to source funding that can be more competitive than their own market. For example, on August 2nd, Fitch downgraded the U.S. credit rating to AA-plus. That did end up triggering further pressure on U.S. Treasury rates, which shifted higher and that had a knock-on effect on coupons for corporate borrowers. This effect was specific to U.S. dollar market, which can create competitive opportunities in other currencies for issuers that have the capability to access that market. What is your outlook for the Canadian market and your advice for issuers?
PD: Yeah, so I think navigating the market has been as challenging as ever and trying to pick and choose the ideal window ahead of time is increasingly challenging. As was the case in 2022, we saw 50% of supply come from just 10% of issuance days in the first half of the year. You have central bank dates that are coming up that are going to be key market movers. You're going to have economic indicators that are, again, increasingly important for the direction of interest rates going forward. And I think ultimately all market participants are keying in on what that next bit of information or what that next bit of economic news is that is going to be moving the market. And so, as it relates to providing advice to borrowers, I think it's getting ready and being as agile as possible to pick and choose those windows when they're presented to you, as opposed to trying to dictate when the right market window is.
So it's a little bit of a nuance just in light of everything that we're seeing. And so I think despite the challenges, however, that we're seeing, we did see the new issue markets reopen very quickly post SVB and Credit Suisse in March. In fact, the Canadian market was the first credit market globally to see new issues come back, which I think is a great sign to the resiliency in the depth of the investor base in our market. And so while there will likely still be challenges, we do expect to see windows of opportunity for borrowers to be able to tap into. It's just a matter of when and I think recalibrating expectations when those opportunities do present themselves.
FA: We share the same sentiment Patrick, in the U.S. We expect the market to continue to be pretty actionable and resilient as we continue to deal with a variety of different variables on the macro side, we expect market conditions to allow for issuers to access funding in an efficient manner. Timing will be critical, but we do expect the level of engagement from the buy side community to remain pretty constructive. As the year comes to a close and heads into 2024.
PD: Fadi, thanks again for joining me today. Always helpful to get your views and perspectives on the market.
FA: My pleasure. It was great to talk to you again and share our insights.
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