Riskier assets seeing duration creep up
Duration is increasing in higher beta sectors within credit markets...
It is a well known fact that duration in Investment grade bond indices has been rising for several years.
Duration now appears to be increasing in more higher beta sectors within credit markets such as Sub Financials and High Yield (“HY”).
The high yield index has naturally been increasing in duration as previously Investment grade issuers (with a comprehensive curve) have fallen into the HY index, these entities are most commonly referred to as “Fallen Angels.”
Issuers and Debt Capital Markets desks have been quick to jump on this trend and have been active in extending maturities for HY and Sub Financial paper. I set out some interesting examples below on recent activity that are indicative of a wider trend.
High Yield
Uber just this month retired its old Uber 7.5% 2023 bonds which were issued in October 2018 (5 year bond callable in 2 years).
These were replaced by new Uber 7.3NC3 (7.3yr maturity callable in 3 years) at a yield of 6.25%.
So, Uber effectively shaved off 125bps vs its previous coupon and issued a bond with a final maturity 2 years longer and a call date 1 year longer than its previous issue. Some of the pricing improvement might be attributed to a modest improvement in credit metrics, but also a greater willingness from investors to accept longer duration, in a ultra low interest rate environment.
Sub Financials
This has been a more subtle change with 2 recent issues in Europe that stood out for their long first call dates.
Commerzbank issued its second Euro AT1 in as many months in a no-grow non-call 9.5 year structure. The books were opened with Initial pricing talk of the 7% area for a €500m no-grow deal, rated Ba2/BB- (below investment grade). The deal was eventually priced at 6.5% on the back of more than €2.4bn of orders at the re-offer price.
Commerzbank followed Intesa San Paolo who issued a long call AT1 in August.
Intesa San Paolo upsized a €1.5bn dual-tranche AT1 issuance on 25 August after receiving c. €6.6bn of orders.
This was Intesa’s second AT1 of the year, split into two €750m tranches:
EU750m PerpNC7.5 Fixed at Par to Yield 5.5%
EU750m PerpNC11 Fixed at Par to Yield 5.875%
This is a great outcome for the issuer who is able to set up a smooth maturity profile of Additional Tier 1 debt. For investors in sub financials it comes with additional risks, namely the sell-side’s appetite for holding longer duration sub financial paper. Longer duration credit, particularly perpetuals score poorly under traditional credit risk scoring mechanisms which handicaps Bank market makers’ ability to hold inventory in longer dated sub financials. This translates into higher illiquidity and more gap risk with these types of bonds.
So overall, its a good outcome for issuers in more higher beta sectors that are joining the investment grade issuers in locking in cheap debt for longer.
Duration has been a great trade for investors, especially in 2020, but if there was to be even a small change in interest rate expectations, that could see meaningful capital losses on bonds, starting with the higher beta sectors within credit.