New equity offerings can garner media buzz. Think of recent initial public offerings (IPOs) by Snapchat, Alibaba and Visa. Business media enthuse, investors clamor, and share prices often rise, at least initially.
The fixed income market equivalent – new bonds coming to market – seldom makes headlines. But new bond issuance may be much more consequential, at least for active investors pursuing alpha potential.
A bigger splash
The alpha potential available to active managers when new bonds come to market is significant for several reasons:
- New bond issues are a more frequent and much bigger share of the market. Over the past three years, newly issued bonds represented more than 20% of the capitalization of the U.S. corporate bond market, according to Barclays Point. In contrast, equity IPOs were less than 1% of U.S. equity market capitalization during the period, according to SIFMA and Bloomberg. This is logical because whereas common equity is typically a perpetual security, bonds have finite maturities.
- New bond issuance represents a consistent source of alpha potential. Active bond managers typically buy new issues when they come to market, often a week or more before the securities enter the index at the start of the month. This matters because new bonds tend to come to market at a slight discount (known as the new issue concession) to outstanding issues, hence the alpha potential active managers can access.
Yet passive managers sometimes wait to buy: They risk tracking error if prices move before the bonds join the index; managers also may face limits in how much off-index exposure they can hold. After all, the goal of passive managers is not to beat the index but to replicate and match its performance.
- Active managers can pick and choose. Even though most new bonds come to market with a concession, active managers don’t necessarily buy them. PIMCO, as well as other firms with deep credit research teams, regularly pass on new deals they view as overpriced. Passive managers, by contrast, have an incentive to buy all bonds that enter the index, regardless of price.
Finally, bigger managers often have an advantage in accessing new bonds, especially for larger deals. With billions of dollars of bonds to sell, investment banks create distribution syndicates. Individuals running syndicate desks may rely on a smaller pool of large investors to obtain lead orders and ensure there is ample interest to proceed quickly with the new issue, before borrowing rates rise.
Consider Verizon’s record issue of $ 49 billion in bonds in 2013 to finance its acquisition of Vodafone’s remaining stake in Verizon Wireless. Given the scale of the issue, Verizon offered a spread concession of 50 – 80 basis points, much higher than the average investment grade new issue concession of 10 – 20 basis points. The 10 largest buyers (including PIMCO) received about 45% of the offering, with the top five buying about a third, according to Bloomberg.
Newly issued bonds play a more significant role in fixed income markets than equity IPOs do in stock markets. Getting access can be competitive, and not all managers manage portfolios large enough to absorb large new issues easily. Big deals aren’t always attractive, however – knowing which deals to pass on is critical, too.
Christian Stracke is global head of credit research at PIMCO.
Jeff Helsing is a strategist focused on credit.
For more on active management, please see “Why Bonds Are Different.”