These are strange times in bond markets. The last six months have turned the interest rate cycle — never a very reliable oscillator — on its head.
Not everything is President Trump’s fault of course — but this kind of is.
Since the US attacked Iran on February 28, 10 year government bond yields have risen 85bp in the US, 73bp in Germany and 100bp in the UK.
Yet despite an inflationary, energy-disrupting war with no end in sight, non-government bonds have remained astonishingly healthy.
Since April, rates have taken all the strain. The S&P iTraxx Europe Main and Crossover indices of credit default swap spreads were at 55bp and 260bp on the eve of the war. They peaked at 74bp and 363bp a month later and since May have been back at prewar levels.
Through the last month’s much-headlined “global bond sell-off”, spreads have flatlined. The credit market appears to be sleeping peacefully.
Those engaged in the primary market, however, are always vigilant, scanning the scene for any sign of trouble.
In the last couple of weeks, the buzzword on their lips has been “order book attrition”.
Grindable books
On many a corporate and financial institution deal, hefty books have melted when the spread was tightened.
AstraZeneca’s €2.55bn four tranche deal on August 25 had €8.4bn of demand at the guidance stage, but 44% of that fell away. Caterpillar’s €1.4bn issue the same day had a similar experience.
Swisscom and Tennet Germany’s hybrids suffered attrition of 51% and 52%.
The pattern has continued this week, with a 39% order loss for Autostrade and 52% for East Japan Railway.
Market participants tend to tut and worriedly watch book shrinkage, afraid that this flightiness is an early sign of danger.
It need not be. This is not a linear gauge, in which more attrition equals more stress.
During the jittery post-crisis years, investment banks decided the safest and easiest way to syndicate corporate and FIG bonds was to start with a whacking great new issue concession that no one believed was anywhere near where the deal would be priced, then crank the pricing in as far as they could.
In good market conditions — which in the past few years has been most of the time — they can often get to or near zero, or occasionally reach a negative concession.
Order book contraction is a natural part of this process. Sometimes, when investors are desperate for a deal, it fades to a trifle. But mostly it’s quite substantial. It helps to tell issuers there is some limit to how far they can push tightening.
Nearly always, it’s nothing to worry about — and very often, it’s completely irrelevant.
Irreducible truth
For an issuer, three facts measure the success of a bond issue: how much money it raised; how much it will have to pay, relative to what it could reasonably have expected; and having a diverse investor base.
Investors care about the return and how the note trades in the secondary market — which means issuers that want to please investors concern themselves with that fourth metric too.
Oversubscription is not necessary, but is a means to achieve these ends.
Traditionally and rightly, oversubscription is carefully watched during the bookbuild, as a quantitative clue to the strength of demand and how far pricing can be squeezed.
But once a deal is priced, its usefulness falls away. The secondary market takes over as the true and more accurate gauge of whether the right balance was struck between issuer’s and investors’ needs.
If the bond trades satisfactorily, whether an issuer reached its goal with 170% final oversubscription like AstraZeneca’s deal, 57% like Caterpillar’s or 140% like JR East’s really makes no difference.
Book attrition is a mere second derivative — the degree of change of oversubscription.
All the deals mentioned above, and countless others, have still been generously oversubscribed even after losing 40% to 60% of their orders.
The issuers all got the size they wanted and tight spreads, with often low single digit new issue premiums. And the deals have traded stably since launch, mostly moving only a basis point or two one way or the other.
The heavy attrition on these deals is not a metric of weakness — you could just as well read it as a badge of success. If the spread was tightened so much that half the investors pulled out, it suggests the issuer had ample demand and drove a hard bargain.
Equally — like the quantum of tightening from initial price thoughts to final spread — attrition may indicate nothing more than how excessively cheap the starting price was.
Fussy FIG
In the FIG market in the past 10 days, bankers agree that fund managers are becoming choosy.
Three deals — for BFCM, PKO Bank Polski and Grenke — had unconvincing or unsatisfactory execution, prompting subsequent issuers to tread warily.
This week, bankers were on guard, as govvie yields jerked up to new highs.
On Wednesday, said one, signs of weakening in FIG credit were “now clearly visible, not only in the attrition but from the lower take-up”.
But the correlation between soft execution and book attrition is weak.
PKO Bank Polski’s book declined by a respectable 28% — unfortunately it was never a bog order book to begin with. With just €700m of final demand, PKO had to cut the deal from €750m to €500m. “Aggressive” pricing was blamed: the bank started with a 25bp concession and paid only 5bp.
The book for Grenke’s benchmark was anaemic from the start and ended at €400m, leading it to print €300m after 10bp of tightening, with 15bp-20bp of concession.
BFCM took three and a half hours to get less than €1bn of demand for its 11 year non-call six tier two deal. Observers were baffled by its tight IPTs, though the syndicate said this was intentional, to give investors a clearer sense of intended final pricing, and the bank could claim its €750m deal had hit its target of “at least €750m”. But attrition was not the issue: the sluggish book grew till late on and only fell by 9% in the end.
This week, attrition’s ugly head has popped up all over the place — 51% on Erste Group Bank’s €1.5bn three and seven year senior preferred, for example. But it just looked like fast money dithering. With concessions of 0bp and 2bp-3bp, there was nothing for Erste to regret.
You can’t blame syndicate bankers for worrying — it’s their job. They have to scrutinise every dial for flickers that could indicate investor disquiet.
But it’s worth remembering which is the fuel gauge and which is a reminder to top up your screen wash.