Outlook 2019: High-grade bond supply to drop amid less funding needs, rise in debt costs

By Cristal Cody

Tupelo, Miss., Dec. 31 – Lower investment-grade bond issuance is again eyed for the market in 2019 as demand slows from foreign buyers and funding needed for mergers declines.

High-grade issuers priced more than $1.25 trillion of bonds for 2018 though early December, down from the $1.33 trillion priced in the same year-ago period, according to Prospect News data.

“We are already seeing the negative impact of higher borrowing costs on supply volumes this year, and the same should continue into 2019,” BofA Merrill Lynch analysts said in a report. “We look for higher debt costs to subtract $40 [billion] from supply next year.

“Debt costs are higher not just on the back of rising interest rates and wider spreads, but also due to the cut in U.S. corporate tax rates that came into effect at the start of 2018. As a result, the cost of debt [versus] equity is now approaching levels from before the financial crisis.”

Volume is widely expected to decline about 5% to 10% in 2019.

“We look for gross U.S. high grade new issuance to decline 8% next year to $1.187 [trillion], and net supply to be 22% lower at $507 [billion],” the BofA Merrill Lynch analysts said. “Borrowing needs decline primarily because of less M&A related supply, the higher relative cost of debt, less European Yankee volumes and more reverse Yankee activity.”

J.P. Morgan Securities LLC forecasts 2019 high-grade gross supply of $1.05 trillion, down 10% year over year.

Ron Quigley, head of fixed income syndicate, primary sales and FIG/utilities at Mischler Financial Group Inc., which prides itself on being the nation’s oldest service disabled veteran broker dealer in the United States, predicts a 5% to 7.5% drop in investment-grade issuance in 2019.

A variety of risk factors may impact the high-grade space over 2019, including U.S. and China trade wars and Brexit, according to market analysts.

High-grade new issuance volumes have averaged $1.216 trillion per year since 2013, rising to $1.396 trillion in 2017 and declining to the $1.178 trillion expected for all of 2018, according to the BofA Merrill Lynch research note.

All-in volume including corporate and sovereign, supranational and agency issuance was down 12.25% year over year, Quigley said.

Tax rate a factor

The corporate tax rate cut to 21% from 35% and repatriation of overseas funds after U.S. president Donald Trump established a one-time lower 15.5% tax rate on repatriation of cash in 2018 were some of the corporate market’s biggest factors, he said.

U.S. companies had repatriated about $520 billion of cash by mid-December with as much as $3.5 trillion still held outside the United States to accommodate overseas operational expansions in growing markets, he noted.

“That's very good news for corporate America and the engine that drives world growth,” Quigley said. “However, it is the story of the IG corporate bond market this year as issuance suffered as a result.”

Supply ended with a whimper in December falling short of the $25 billion to $30 billion of volume initially expected for the month. High-grade issuers priced more than $8 billion of bonds over the first half of December.

High-grade corporate-only volume by mid-December was down 11% versus the same period in 2017, Quigley said.

Issuers were nervous in the investment-grade market in December as volatility reigned, which sidelined some deals, sources said. If markets calm down, supply is expected to accelerate in January, in part because financial issuers typically tap the market at that time, a trader said.

January issuance is tentatively projected at about $100 billion to $125 billion, informed sources said.

M&A needs decline

The past year saw a number of major deals, including CVS Health Corp.’s $40 billion nine-part offering of senior notes (Baa2/BBB+) that priced on March 6, 2018, that were spurred by funding needs for mergers and acquisitions.

CVS Health’s transaction was the largest of the year and the third biggest deal on record behind Verizon Communications Inc.’s $49 billion issuance in 2013 and Anheuser-Busch InBev Finance Inc.’s $46 billion transaction in 2016.

Less funding for mergers and acquisitions is expected in 2019.

The pipeline of pending mergers with investment-grade bond issuance implications is estimated at about $333 billion with an implied $76 billion of issuance in the first half of 2019, according to the BofA Merrill Lynch report.

Mergers and acquisition supply volumes are expected to be little changed in the second half of 2019 for a total decline of merger funding needs of about $100 billion, BofA Merrill Lynch said.

JPMorgan analysts said they expect M&A supply in 2019 to be lower than in 2018, “but not by much.”

In a report, the analysts said $39 billion of M&A related issuance has been announced and is pending and another $161 billion is possible for 2019.

In 2018, JPMorgan analysts estimate there was $238 billion of mergers and acquisitions issuance, which included $213 billion of actual issuance and $25 billion of announced and pending M&A related issuance.

In 2017, M&A-related high-grade issuance was $143 billion, according to JPMorgan.

“M&A issuance has represented 18% of high-grade bond supply since 2015,” the analysts said.

Investor shift eyed

Another factor in the decline in deal volume in 2019 will be from less foreign buying because of the higher cost of dollar hedging, the BofA Merrill Lynch analysts said.

Inflows to bond funds and ETFs also are expected to be lower in 2019.

“This is a major shift as these two types of investors bought 100% of net supply during the period 2015-2017,” according to the BofA Merrill Lynch note. “Comparing next year to the peak in 2017 we expect foreigners and bond funds/ETFs to net buy 60% less. While this is a dramatic change the key mitigating factor is that net supply declines materially as well. We think net supply is more than 40% lower in 2019 than the peak year of 2017.”

Flows follow returns, and in October there was a $23 billion outflow from high-grade bond funds and ETFs, the largest since June 2013.

JPMorgan analysts said mutual fund and ETF investors avoided high-grade bonds in 2018 after a strong year of inflows in 2017.

Green bond issuance

Looking ahead, green bond issuance remains a small segment at only about 0.2% of all bond issuance in 2018, but the sector is making an impact with corporate and SSA bonds priced to fund positive environmental and social changes, sources said.

International Bank for Reconstruction and Development, or World Bank, sold a $1.3 billion equivalent of dollar- and euro-denominated green notes on Nov. 14.

The deals bring World Bank’s green program to $12.6 billion through 150 green bonds in 20 currencies and mark the 10-year anniversary of the bank’s first green bond that was issued in November 2008.

During the same Nov. 14 session, Kilroy Realty, LP sold $400 million of 10-year guaranteed green senior notes.

ING Groep NV brought $1.25 billion of seven-year green senior notes to the primary market on Nov. 8.

U.S. green bond issuance made up about $33.6 billion of the global volume through October, down about 13% year over year but still the biggest issuer ahead of China’s $30.7 billion of green volume in the first 10 months of 2018, Nordic financial services group SEB said in a December report.

The U.S. market has the potential to see about $45 billion of green bond volume “with much stronger contributions from corporates next year,” SEB said.

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