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US: Corporate Issuance and Swap Spreads • Summer doldrums: USD high grade corporate bond issuance tends to be lowest in the months of July and August, averaging USD 48bn (5.6%) and USD 58bn (6.7% of total issuance for the year), respectively, over the past five years (Chart 3). Despite predictions by some analysts of an increase in corporate issuance for the summer of 2010, July issuance so far is right on trend at USD 33 billion, and will likely slow through the remainder of the month as US earnings season enters high gear. • Distortions in 2008 and 2009: Corporate issuance trends in 2008 and 2009 were deeply affected by (a) the burgeoning economic crisis, peaking with the failure of Lehman in Sept 2008, which practically shut out financials from the market for a time; and (b) a huge rebound in issuance due to both FDIC guarantees (Chart 3) and a surge in Yankee bonds (Chart 1) as a favourable move in the cross currency basis made the US markets more attractive. • 2010 trends: On a cumulative basis, 2010 high grade corporate issuance appears in line with 2006 and 2007 (Chart 2). On a sector basis, Yankee bonds have dominated issuance YTD (Chart 1), having surged in January-April, while US financial issuance appears to be lagging. We expect a moderate pick-up in issuance as blackouts due to earnings season and summer wane. However, impending changes in debt and capital composition due to financial reform combined with only USD 34 billion of USD 330 billion outstanding of FDIC guaranteed debt maturing through year-end may restrain offerings from the financials. We expect total high grade issuance for 2010 may hover around USD 850 billion. • STRATEGY: Expect swap spreads to be pressured tighter as issuance increases through the fall. Although corporate supply is typically a second-order effect on spreads, there has been a diminished influence of mortgage hedging and the slope of the yield curve in the current environment. This opens the door to corporate issuance possibly having an outsize effect. Swap spread regression models There is a rich and evolving academic literature on what drives swap spreads. Standard models are typically multivariate linear regressions which assess Chart 1: High Grade Corp Issuance (by sector) Amount (blns) 1,400 1,200 1,000 800 600 400 200 0 163 287 86 Yankees Financials Utilities Industrials 238 364 248 242 416 400 166 199 205 the correlations between swap spreads and the following known empirical driving factors (roughly in order of importance in the pre-crisis environment): • the slope of the yield curve and the level of rates; • the refinancability of the mortgage market (to capture the influence of mortgage hedging, understanding that this factor is of course correlated to the first two); • liquidity premium; • Treasury supply; and • corporate debt issuance (where fixed-rate debt is often rate-locked ahead of issuance and then swapped back to floating, resulting in a tightening bias on spreads). Technical note: most swap spread models are run on spreads only up to the 10-year. The 30-year swap spread across currencies has long been acknowledged as something of an anomaly, with a dominant factor being the hedging needs of exotics options desks and therefore volatility. It has only been with the recent use of the swap spread multifactor 541 375 274 270 94 87 2005 2006 2007 2008 2009 YTD 2010 Source: Informa Global Markets, BNP Paribas Chart 2: Corp Issuance (cumulative by year) Amount (in billions) 1,400 1,200 1,000 800 600 400 200 - 2005 2006 2007 2008 2009 2010 ~195b (16%) of 2009 iss FDIC gtd JAN FEB MA R APR MAY JUN JUL AUG SEP OCT NOV DEC Source: Informa Global Markets, BNP Paribas Mary Beth Fisher 16 July 2010 Market Mover, Non-Objective Research Section 24 www.GlobalMarkets.bnpparibas.com
term structure models mentioned below that 30-year spread dynamics have been incorporated with some success into the standard framework. One of the drawbacks to linear regression models is that they can’t capture any tendency for the influence of the factors to vary over time or operate across different horizons. For example, the effect of corporate issuance on swap spreads acts as a rather short-term effect – e.g. the swapping of a fixed rate issue to floating exerts tightening pressure on spreads on the day the issue is swapped. Corporate issuance also tends to exhibit seasonal patterns, as evidenced in Chart 3. A pick-up in Treasury supply tends to be a more fundamental economic signal, and its “normal” tightening bias on swap spreads has been shown to act over longer periods of time. Of course the current economic environment has turned many of these “normal” factors on their heads. The enormous amount of Treasury supply hasn’t appeared to exert much pressure on front end spreads, and the impact of convexity hedging of mortgage portfolios – which used to be a dominant factor correlating 5y and 10y swap spreads to the level of rates – has dropped off dramatically. Swap spread term structure models These changes in the economic environment and clear alterations in the strength of various correlations have increased the use of full blown term structure models to analyse the term structure of swap spreads. These stochastic models attempt to capture the variability of economic factors, curve and volatilities on swap spreads over time. An excellent example of this approach is detailed in the December 2008 paper, “Modeling Swap Spreads in Normal and Stressed Environments”, by Vineer Bhansali, Yonathan Schwarzkopf and Mark Wise. Although a complete synopsis of this paper and their approach is beyond the scope of this article, it is worth repeating several of the conclusions. “...a robust model of swap spreads... should capture the key factors we know that describe the movement of swap spreads. These factors include the level and shape of the sovereign yield curves, the relative supply of risky to riskless debt, the activity of mortgage hedgers (convexity hedging), and the movements in credit spreads. (pg 2) It has been shown that one of the drivers of the swap spread is the slope of the yield curve. [The] value of the 10 year swap spread was regressed versus the yield curve slope for data spanning January 1997 to August 2003. As the slope of the yield curve the author used the difference between the 10 year and 2 year rates and the linear regression coefficient was calculated to be −0.19. The negative value of the coefficient implies that the swap spread tightens as the curve steepens. This coincides with the intuition that as the yield curve steepens market players prefer to be the fixed-rate receiver in a swap and commercial banks will be less inclined to hedge their short term variable rate deposits reducing the demand to be a fixed rate payer. This will reduce the demand for swaps and as a result will decrease the swap rates and tighten the spread... Interestingly, the negative dependence of the swap spread on the slope of the yield curve breaks down around the summer of 2007... Starting at around June 2007 the swap spread widens as the slope of the yield curve steepens. ... This behavior seems to be associated with a breaking of the usual dependence of the swap spread on the slope of the yield curve.” Corporate issuance and swap spreads As the paper points out and the markets have experienced, swap spreads traversed a period, and may still be in it, where the slope of the curve is not a dominant driver. Our experience over the past year, since the paper was published, also points to the diminishing effect of mortgage hedging activity and Treasury supply on spreads. So what’s left? Clearly the liquidity premium – which in some sense can become a “catch all” factor – appears to be dominating front end spread dynamics. Historically corporate issuance was a second-order influence on spreads. Now that corporate issuance patterns appear to be normalizing somewhat from the event-driven patterns of 2008 and 2009, it’s possible that the supply of risky debt may become more influential on spreads. Although we expect only a moderate pick-up in high grade issuance as we exit the summer doldrums, we think this might have a more concentrated than normal tightening effect on swap spreads – particularly in the front end – given the absence of influence from the other “normal” drivers. Chart 3: US High Grade Corporate Issuance (monthly, since 2005) Amount (in billions) 180 160 140 120 100 80 60 ~30% in Jan09 FDIC gtd ~20% FDIC gtd ~36% FDIC gtd 2005 2006 2007 2008 2009 2010 Lehman failed Sept 08 ~100b (86%) of Dec 08 issuance w as FDIC guaranteed 40 20 - JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Source: Informa Global Markets, FDIC, BNP Paribas Mary Beth Fisher 16 July 2010 Market Mover, Non-Objective Research Section 25 www.GlobalMarkets.bnpparibas.com
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