Finding alpha in high grade bonds? Nip it in the bud
JP Morgan’s investor survey found 19% of high grade investors think new issue premium (Nip) will be the best source of alpha in the year ahead. With yields on the floor, it makes sense, but it is sign of a deep malaise in the fixed income market.
What’s in a new issue premium? The point of it is to move a lot of bonds. If daily trading is around €5m ($5.65m) and you want to place €1bn, selling the deal cheap to the curve makes sense. A little price pop around new issue helps the medicine go down and helps leads place the bonds in the right hands. Arguments about how large the premium is, or should be, are a mainstay of debate in the debt markets — and therefore in the pixels and pages of GlobalCapital — but the concept is part of the primary market furniture.
This makes a recent note from JP Morgan’s credit team all the more worrying. The team surveyed a broad range of high grade credit investors, and found that 19% said that they expected that Nip would be their best source of alpha in 2015.
The rest of the possible alpha sources were more conventional — maturity extension, corporate hybrids, lower-rated credit, and cross-currency investment split the rest of the votes, with cross-currency investment on 27% and corporate hybrids on 22%.
But all of these share the characteristic that they are in some sense investment decisions — ways to take more risk or access different assets from the investment benchmarks — not simply artefacts of the debt market’s structure.
JP Morgan’s analysts probably left off the option to generate alpha through general brilliance and wise investment choices (surely 100% would have ticked that box), but even so, if a substantial minority of investors are hoping Nips are their largest source of alpha, this implies a certain indifference to credit quality.
The best bond to own becomes one with a fat premium to the curve, not one from a rare issuer or a sought after credit, or something undervalued by the market with a good but untold story. Buyers of investment grade credit ought to expect to do less credit work per issue than their peers in high yield or ABS — that is, after all, the point of something being investment grade — but it would be nice to believe that corporate metrics or cross asset relative value were more important than the price pop after the issue.
Chasing alpha in Nips also puts enormous power in the hands of syndicate and issuers. The long bull run in bonds has already made primary bonds a seller’s market, but if outperformance is driven by new issue premiums, then getting allocation in cheap new issues becomes the main part of investing, not just a part.
This, in turn, messes up investor incentives. Sucking up to the sellside, rather than principled conviction positions, will be a better way to outperform. The market will fail to discipline issuers provided they throw some basis points on the table.
The market has some natural ways to heal itself. Syndicates will not smile on investors which show up for a juicy Nip but fade out as guidance tightens, or flip their bonds quickly to monetise the “alpha” in the new issue price — that is what they are paid to do.
But while yields remain this low, it is hard to see how Nip could return to its role on the sidelines. With top notch issuers (such as Unilever on Tuesday, January 27) placing new issues at 17bp, a new issue premium that might be 3bp or 5bp could make up a decent chunk of available spread, and with trading spreads of perhaps half a point (based on MarketAxess’s bid-ask spread index) there is little alpha to be found in churning high grade portfolios.
The market, therefore, cannot do much about it. But if, for some investors, Nip is the main event, rather than a sideshow, we should take this as a sign of a deep sickness — a symptom of liquidity addiction which will need to be cured.