Market Insider

This market has had a wild start to the new year

Strap in for a volatile year in bonds, equities: Expert
Strap in for a volatile year in bonds, equities: Expert

The corporate debt market is kicking off the new year with a bang.

Companies have issued a whopping $88.6 billion in high-grade debt in 48 deals since Jan. 2. The first week of the year started off at a record pace, but the month-to-date total is second only to the record $92.1 billion in the same period last year. Last year, there were just 34 deals but the total volume was inflated by a $46 billion AB InBev deal.

Another $26 billion could come to market next week, according to estimates from Informa. The beginning of the year is normally an active period, but the amount issued so far is already more than half the $125.6 billion issued during the full month of January 2016 — and that was also a record, according to data analysis firm Informa Global Markets.

The gusher of new debt also coincidentally comes as Congress is about to discuss corporate tax reform, which could include eliminating the deductibility of interest paid on debt.

The first week of the year saw $53 billion in investment-grade issuance in just four days. "It was led by financials," said Informa analyst Chris Reich. "Financials accounted for 85 percent of the total of weekly volume." More of those could come in the coming week, when markets reopen Tuesday after the Martin Luther King holiday.

Jon Duensing, head of corporate credit at Amundi Smith Breeden, said the pace in the first few days of the year was well above normal, but it fits the pattern of financial firms coming out early in the new year — and they normally do it ahead of the earnings period, which for banks kicked off in earnest Friday. Issuers this year included Citigroup, Barclays, Credit Suisse, Caterpillar Financial and Ford Motor Credit.

One factor driving the volume of deals could be expectations that interest rates will be get higher as the year goes on, with the Fed expected to hike three times in 2017.

He said it's not likely the rush is due to tax law changes. "It's probably more related to seeing markets that are open, investors that are willing to invest [and] the availability and cost of capital," Duensing said.

In a note, Goldman Sachs economists said they expect some type of limit on deductibility of interest expenses, and they suggest three options for Congress in dealing with it: "…changes to interest deductibility and the depreciation of capital investment appears fairly likely, as lawmakers have debated such changes for years and incremental options are available," they wrote.

The first way would be to grandfather interest payments on existing debt and allow companies to continue to depreciate existing capital expenditures. But future debt would be covered by the new law and capital expenditures would be fully expensed. Alternately, lawmakers could gradually phase out the old system in steps. A third way was proposed by Trump himself, and that would be to offer taxpayers a one-time choice of staying in the old system with full interest deduction and partial depreciation deductions or switching to the new system.

"That could be very transformational. There's still a lot of question marks," said Duensing. "There's still a lot of uncertainty about what the final rule of law would look like." He also said there are a lot of variables and options that could be discussed.

"The idea might be if you remove the interest benefit from debt, maybe if you go buy a widget-maker instead of depreciating the widget-maker, you're allowed to completely expense that," he said.

He said if the law does take effect in some form, it could mean a lot of changes ahead for the market. "The investment grade corporate bond market is a little under $6 trillion. The U.S. dollar high-yield market is $1.5 trillion. Both of those markets have grown relative to the size of the U.S. economy, and there have been questions of how sustainable is the continued growth of the corporate balance sheet on the corporate debt side. This could be one of the catalysts that slows that growth and perhaps reverses it. We're at letter A and a long way from Z," he said.

Another part of the tax discussions would be more simple to enact, he said. That is the proposed repatriation of funds kept offshore by U.S. corporations, which could be given a one-time break to bring the cash home. There has been much talk about whether companies would use the cash to buy back stock or issue dividends, or use it to reinvest in their businesses in the U.S., as the Trump administration would like to see.

Duensing sees a third alternative. "Once that money goes on shore, we think they could retire and pay down some debt," he said. He estimates about half of it could be used for debt repayment, since companies already raised debt to buy stock, with the idea that they had the cash overseas.

Duensing said the idea of the returning capital going to retire debt has had a positive effect on some spreads of issuers in the investment grade market.

Bank of America Merrill Lynch analysts wrote Tuesday that they believe issuers saw higher rates coming and decided to rush to the market early this year. They had expected a total $90 to $100 billion of issuance for the entire month of January.

The analysts have previously said they expect 17 percent less corporate issuance this year, due to rule changes around the one-time repatriation tax holiday for overseas corporate cash. According to Informa, 2016's investment grade issuance was a record $1.28 trillion.

"That would ease supply pressures for US companies with significant cash balances held abroad which means particularly in the Technology and Pharma sectors. Hence we look for a $50bn reduction in supply next year due to potential repatriation of foreign cash," they wrote.

The Bank of America analysts also said they see a favorable market in the early new year with tighter spreads. They note that demand is picking up, and they expect the supply to slow down.

"High grade corporate bond prices have rebounded about 1.5 percent from their December 16th 2016 post-election lows and bond fund/ETF flows have reacted predictably. Hence during the most recent week (ended Jan 4th) we saw a large inflow of $2.71bn - more than offsetting the $2bn cumulative post-election outflows prior to that. This week also saw the return of foreign buying after their absence in December, due in part to year-end dollar funding strains," they wrote in a note Tuesday.