March 22, 2013 / 6:15 PM / 6 years ago

Nervous investors demand more protection against rising rates

NEW YORK, March 22 (IFR) - Borrowers this week responded to investor demands for protection against rising interest rates by adding floating-rate tranches to their deals and issuing primarily shorter-dated maturities.

Bank of America and Capital One boosted their issues by US$1.5bn and US$250m respectively, by adding floating-rate tranches at the guidance stage. Citigroup jumped into the market on Friday to offer benchmark three-year fixed-rate notes.

On Wednesday, Comcast-guaranteed NBCUniversal offered US$1.4bn of three- and five-year floaters with launch spreads that tightened from initial thoughts and priced as much as 5 basis points tighter than its comparables.

The same day, satellite provider Intelsat added a US$500m five non-call two-year deal at the last minute to what ended up being a US$3.5bn trade that was double its initial size.

Demand was so strong that the five-year tranche jumped 2.25 points in price in the aftermarket. Five-year final maturities are not the norm in the US high-yield market and their recent appearance and popularity is directly due to investors clamouring for short-dated paper.

Many funds have been preparing for rising interest rates for the past year, but bankers have seen a surge of demand in recent weeks, as investors who are normally indifferent to floaters flood the market in search of paper.

“We have seen a material increase in new issuance as well as spread compression in floaters in the last few months as the buyer base has expanded beyond the traditional securities lending community,” said Brendan Hanley, managing director in debt capital markets at Bank of America Merrill Lynch.

“Many of the new investors are looking for protection from rising rates.”


So far this year there has been US$32.3bn of investment-grade floating-rate notes issued, more than double the US$13bn issued in the entire second half of 2012.

Investors have increasingly demanded shorter-maturity fixed-rate notes, which do not sell off as much as bonds of seven years or more when Treasury rates rise.

Issuance of five-year and shorter fixed-rate notes has accounted for about half of the new issue volume so far this year.

“This dramatic rise in demand for floaters and short duration product is evidence that investors are growing increasingly concerned about interest rate sensitivity and the impact it could have on their portfolios, “ said Edward Marrinan, chief macro credit strategist at Royal Bank of Scotland in the Americas.

Retail investors in particular are rotating out of long-term investment-grade funds and into others that have little to no duration risk or are completely floating-rate securities. The shorter the duration of a bond, the less impact a widening of the Treasury yield has on its returns.

“We estimate that short-term funds account for 75% of high-grade inflows this year, compared with only about 40% last year,” said Hans Mikkelsen, credit strategist at BofA Merrill.

Investment managers like Prudential and Pimco are seeing the size of their absolute return funds, which hedge out duration risk, balloon in size in recent months.

“We have seen a clear rotation from traditional intermediate duration bond funds into funds that have little or no interest rate risk, like our Absolute Return Bond Fund,” said Michael Collins, one of Prudential’s most senior portfolio managers.

Funds like the Prudential Absolute Return Bond Fund are designed to largely hedge out all of the bonds’ duration through the use of Treasury futures and/or interest rate swaps. But, even here, the fund managers are cognizant of the underlying credit risk and may utilize shorter-maturity securities to limit spread volatility.

Duration risk is the name given to the greater drop in returns that longer-dated bonds suffer, compared with shorter-dated bonds, when Treasury yields rise.

The search for protection is broad and has translated into a dramatic expansion of the kind of floaters offered.

What was once the exclusive domain of securities lenders and money market funds — and mostly two years in tenor and shorter — has now been embraced by asset managers, pension funds, corporate portfolio managers and bank portfolios who are coming in, demanding bigger deals and offerings in five-year and even 10-year maturities.

The demand for floaters has steadily increased as every new piece of good economic news convinces more investors that US rates have truly bottomed.

The 10-year Treasury yield hit a low of 1.39% on July 24 last year and started a steady slow rise in early December to its current level of around 1.94%.

This year the other shoe has dropped in the form of better-than-expected unemployment numbers, raising concerns that the Fed will soon start talking about exiting its QE strategy, at which point rates could suffer a severe spike.

“People are getting a little edgy about the possibility that rates continue to grind higher and that the Fed will start to talk about an exit strategy,” said Collins.

Savvier investors have been making money at every knee-jerk reaction of the general herd at a jump in rates.

“The expectation of just how quickly and how far rates could increase has often been out of sync with what has really been a very well contained move up,” said Collins.

“But as you get intermittent spikes in rates and spreads there are opportunities to go long duration and take advantage of the widening of 30-year corporate bonds.”

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