Credit’s cash pile ready for September supply

We have long harked on about the strength of the technical in credit, with solid fundamentals, resilient inflows and defensive positioning continuing to provide a tailwind for the market.

Barring any macro surprises, we expect this to continue, even with spreads towards the bottom end of longer-term averages. September is usually a busy month for new issues, as management teams (and their investment bankers) come back from what is usually a quiet August. Sometimes, this causes a bit of indigestion as buyers might struggle to absorb the increased levels of supply. This time around it does not look like this will be a problem.

Looking first at flows, the summer lull has done nothing to dent the steady drip of money into credit markets. Investment grade (IG) funds have enjoyed net inflows for 17 out of the last 18 weeks, while high yield (HY) funds have seen fifteen consecutive weeks of inflows, with the largest week of flows into European HY this year coming in the middle of July. This comes at time when coupon flows – the cash fund managers generate from the interest paid on the bonds they hold – remain elevated versus historical averages, adding more to investors’ cash balances. In fact, coupon flows alone would be enough to absorb a significant percentage of projected net supply in HY this year, both in the euro and dollar markets.

Adding to this dynamic is a manager base that remains defensively positioned, particularly in Europe. Fund managers’ average fund beta (a fund’s sensitivity to its underlying benchmark) is below the 10th percentile (the 1st percentile being the lowest beta they have run over the past 10 years, 100th being the highest) in both European IG and HY, according to estimates by Goldman Sachs. Interestingly, the story is different in the US, where fund managers are running fund beta around the 40th percentile in IG and almost 90% in HY. Cash balances have steadily increased over the past few months and remain particularly high in IG funds. 

We generally expect solid demand to be met with solid supply in September as the typical post-summer primary deluge opens up, particularly in IG. In dollars, gross supply of $175-200bn in IG and $30bn in HY is expected next month, while European IG supply is expected to reach €70-80bn (€25-30bn of which is expected in financials). European HY has a comparatively light pipeline after a busy spring/early summer, with €7-10bn expected in September.

We expect next month’s supply to be well absorbed by the market. With leveraged buyout (LBO) and M&A activity still relatively limited, most of the issuance coming to the market continues to be refinancing. Gross supply in euro IG and HY for example has equated to €640bn and €80bn respectively year-to-date, while net supply has been €140bn and €30bn (in USD IG, net supply is running around 35% below the three-year average at $260bn). It's worth saying that one area where net supply has increased has been HY, particularly in Europe, but that comes after multiple years of negative net supply.

From our perspective, we view the upcoming supply as a good opportunity to go fishing for interesting ideas. We continue to be highly selective when picking credits, focusing on those businesses that generate strong free cash flow at attractive loan-to-value levels, and ones that we think can be comfortably underwritten through the cycle, hopefully with an attractive new issue premium. Given the weight of cash on the sidelines, we are perhaps unlikely to get the latter.