With interest rates and underwriting spreads at historically low levels, some market participants now feel that underwriters and portfolio managers are walking a thin line to do a profitable business.
Underwriting spreads have plunged over the past 20 years, with underwriters making $7.77 per $1,000 face value of bond issues in 1996 compared to just $4.64 in 2015. Low supply, rock bottom interest rates, and intense competition for every deal that comes to market have investors searching for yield wherever they can find it, a trend one well-known market analyst said could be problematic.
"One of the problems that markets have with very low rates is the inability to distinguish between strong credits and weak credits as everybody continues to grab for yield," said George Friedlander, who was Citigroup's top muni strategist until stepping away earlier this year to pursue policy interests.
"The market has a challenge in identifying weak or deteriorating credits based on how the market is pricing," said Friedlander. The longtime strategist said he sees the current market conditions as a natural part of a market cycle that will eventually come to an end, but said he does not believe interest rates will significantly rise soon and that it could take a long time for the market to catch on. A series of credit crises could be the impetus for the change, Friedlander said.
"This is a remarkably frustrating time for a good portfolio manager with integrity," Friedlander said. "This is a very frustrating time for those who insist on quality."
While some portfolio managers who spoke with The Bond Buyer said they didn't feel as affected by market conditions as Friedlander believes they are, Florida bond finance director Ben Watkins described investors as being in "a race to the bottom."
"From an issuer's perspective, the market's been very good for a very long time," said Watkins, who said he personally pays less attention to spreads and more to the Municipal Market Data triple-A scale. "Banks still have an appetite to put paper on their books through the direct loans. That's helpful."
"Investors are so starved for yield that they're moving down the credit spectrum, and it's sort of a race to the bottom, said Watkins. "That just further exacerbates the credit spread compression."
"They're not being adequately compensated for moving down the credit spectrum because credit spreads are so compressed," Watkins continued. "So when rates start moving back the other way as they inevitably will, the lower-rated credits won't hold their value like high-grade paper will."
Watkins said that hardly anyone thinks rates will significantly move before the election, and that over the past few weeks investors have been put "back in the drivers' seat" with a glut of supply hitting the market.
"Everybody now is focused on December," Watkins said, when the country will know who its President-elect is.
One banker said that he doesn't see a strong correlation between interest rate spreads and underwriting spreads, noting that some firms won't push their price to underwrite a deal, as they see greater profit potential in trading and secondary trading, which explains some of the low bidding that is taking place within the industry.
"I also think some firms see a greater profit potential secondary market trading," the banker said. "In the primary market, at some point in low spreads, the institutional investors know that the underwriters will not aggressively price the bonds."
"For issuers, the all in price is either optimal or not and I don't see that changing," he said. "Every issuer doesn't always have the luxury of convincing boards that they are making the right choice [if one underwriter is more expensive on takedown than another]. Out of all the variables, underwriter discount is an easy one to measure."
He noted underwriters don't have to bid low and issuers doesn't have to use price as a measure, as it may be the easiest metric to use but it might not be the best way and it is deeply flawed.
"Everyone has contributed to it and we are in this together," the banker said. "This is a challenge to every firm out there and its part of the business landscape we face. It's up to all the players in the industry to find a market level that works for everyone. Underwriters have done this to themselves."
