Mid-year bonds update: A resilient first half of 2024, but what comes next?

Announcer: You’re listening to the Scotiabank Market Points podcast. Market Points is part of the Knowledge Capital Series, designed to provide you with timely insights from Scotiabank Global Banking and Markets’ leaders and experts.

Patrick Dabiet: Hi, I’m Patrick Dabiet, Managing Director and Co-Head of Canadian Debt Capital Markets. On this episode of Market Points, I’m joined by Fadi Attia, Managing Director and Head of U.S. Debt Syndication. We’ll be discussing how the debt capital markets have evolved since the start of 2024 and what lies ahead for credit markets as we approach the U.S. Election.

Fadi Attia: Always a pleasure to catch up with you on these market developments. We definitely have seen a lot of interesting trends and unexpected turns this year.

PD: So, let's take a snapshot of the first half of the year. What do you think?

FA: Okay, so how would you characterize the debt capital markets in Canada?

Any surprises?

PD: So, it was a very eventful first half of the year in Canada, Fadi, for issuance volumes. We set a new all-time record at $85 billion. That far surpassed our estimates and the market's estimates. I think what’s notable is a few things. First and foremost, Canadian banks who typically drive issuance activity in our market were quieter than anticipated, while corporate borrowers came to the market in a fairly broad and material fashion.

I think the other interesting thing that we took away was maple borrowers who are foreign borrowers issuing Canada were, were quite sizable, issuing $8 billion of supply, which is some annual volumes for previous years. I think it was all, relatively well digested by investors.

That being said, there were definitely periods of time where the market felt a little bit oversupplied, but I think ultimately we’re setting ourselves up well for the second half of the year. How about from your side, Fadi? How did the first half of the year play out in the U.S. investment grade markets.

FA: So Patrick, I would say, first half of 2024 was exceptionally busy. We’ve seen a record amount of issuance, $900 billion of supply. This marks the fastest first half that we’ve seen for quite a bit of time since, you know, excluding 2020, but as you go back a number of years. Of note, we’ve had every single month this year record more than a hundred billion of new issues, and Jan and Feb were actually record months for issuance for these months versus historic volumes.

What’s been driving a lot of this activity is just an incredible amount of positive sentiment out there in the market. You’ve seen that sort of triggered by the Fed’s pivot effectively in their December meeting in 2023. You’ve seen an outsized amount of issuance volumes sort of work their way through the market, but spreads actually been pretty resilient.

If anything, spreads continuously recorded multi-year tights throughout the first half. Naturally, issuers took advantage of these constructive funding conditions. We've seen issuers access across the curve for sizable amount of funding, and we see them effectively re-rack low spreads in a variety of different maturities.

We did see bouts of macro volatility work their way through the first half, but it didn't really have much of an impact on execution. If anything, it created a higher degree of resilience and highlighted the robust nature of the investment grade market.

So, Patrick, what do you make of the higher-than-expected activity, record breaking issuance? What are the catalysts in your view?

PD: Yeah, so in terms of why supply ended up being larger than anticipated. I think there’s three main factors, two of which were expected. So, those two would be the reemergence of sectors that were kind of lying dormant while they readjusted to higher rates. Sectors like the high yield market, which saw zero supply last year, came back with very meaningful and broad volumes in the first half of the year.

The second of which was, again, was anticipated was timing of issuance and borrowers proactively avoiding the second half of the year, trying to get away from any potential volatility around the U.S. election. They brought their issuance forward.

I think the third factor that was maybe not as anticipated was the opportunity that borrowers saw to take advantage of more attractive deposit rates. So, effectively, they would issue, and take those proceeds, deposit them at rates that were either equivalent or even higher than what they were paying in terms of borrowing that money. And so that is an incentive, a material incentive to some of those borrowers to take advantage, and we saw that play out ultimately in the first half of the year.

What about from the U.S. perspective? What were some of those key supply drivers?

FA: So, I would say there were a combination of factors, and I think most of these factors were centered around the Fed messaging to the market. I think, as you remember, back in December 2023, the Fed’s messaging was pretty clear as far as their, willingness to start considering easing throughout 2024.

The market read this as the potential pivot that they’ve been waiting for quite a bit of time and went ahead and priced in 175 basis points of rate cuts, which seems a lot looking back today, but, certainly the market did get ahead of itself and sort of priced in a significant amount of easing into the market.

That in itself has boosted confidence across risk assets, including credit. You’ve seen a tremendous amount of performance in credit spreads. You've seen this also increase the amount of momentum from the inflows that are on the buy side, and that's created a huge benefit for issuers in their ability to effectively take advantage of deeper books, access the curve very efficiently, maintain a very healthy amount of price leverage and execute deals with ease.

You've also seen the market start to slowly fade their expectations throughout the first half of 2024, particularly around Feb, where they started to take back some of this easing pricing that’s been worked into the market at the beginning of the year, and that did trigger a bit of sell off in rates and rates started to drift about 4%. Still way below where we experienced rates back in October, which was the near highs as you look at the sort of last nine months.

But nonetheless, the increase in rates didn’t really impact issuer’s ability to access the market, and it certainly did not impact the willingness of investors to be invested in many of the new issues that's come out of the investment grade market.

PD: So Fadi, you just highlighted, I think, what was the biggest evolution on the interest rate policy side in the first half of the year and how expectations started off sky high for rate cuts and progressively have been faded, to the point where we haven't seen a cut yet from the Fed. We started to see that in Canada. But how do you think that created a market dynamic for both issuers and investors?

FA: The confidence in the Fed cuts did dramatically get scaled back from February of 2024 and that has created a number of opportunities, both for investors and issuers, and I think part of those opportunities being centered around the diversions that you've seen on Fed policy across the globe, as you mentioned, within the various jurisdictions.

Primarily for issuers, it created opportunities for them to effectively access different markets around the world. Take advantage of these funding opportunities to be able to either crystallize lower coupons than what they can achieve in their domestic markets in the U.S. Or more competitive funding on a spread basis as you swap it back into U.S. dollars. On the investor side, the carry that's offered in U.S. Dollar assets via the credit market were incredibly attractive given the higher rates in the United States versus other developed markets. That has helped continue the amount of inflows that we've seen in the market, not just from the domestic investors who typically tend to account for the biggest portion of liquidity in our markets, but also for offshore investors who are looking to take advantage of these opportunities.

PD: So that’s really interesting because, ironically pushing off cuts while it didn't act as a catalyst for domestic accounts, created a more attractive investment environment for foreign investors to come and take advantage of higher yields for longer in the U.S.

FA: Absolutely, and I think that just simply added an incredible amount of liquidity to our markets, which then translated into multi-year tights when it comes to spreads, just given the attractive nature of the total returns that investors are able to achieve as they access the U.S. dollar assets.

And then on the flip side, spreads compressing progressively throughout the first half just given that these dynamics of demand is so high that it's driving those multi-year tights and spreads.

PD: Very interesting.

FA: Obviously, these dynamics are going to continue to evolve and they're going to have implications across sentiment.

I do think what's going to be important is the narrative around why is there a divergence in central bank policy when it comes to rate cuts or easing. I think that narrative is very important, for example, if that narrative is being driven by a material slowdown in some of the economic indicators in any given jurisdiction, that can have a negative impact on general investor sentiment because that starts to highlight potential weakness in credits that could be alarming and therefore could translate into a widening pressure in spreads.

And I also think the other factor that comes into play here is the volatility that the market tends to sometimes experience in the rates market. And when I say rates, I'm specifically referring to U.S. treasuries. Volatility always has a negative impact on investor sentiment. It’s less so the absolute level in terms of where rates are or are settling in, whether it's higher or lower, I think it’s just the manner at which rates get to a higher or lower point is more important. So it happens in a very volatile fashion, I think that can have negative implications as far as investor interest in the market, and they tend to sort of price that in by charging bigger premiums for borrowers to access the market because they simply don't know where that credit risk valuation is effectively going to settle into the secondary market given all this volatility that's playing out from a macro perspective.

Patrick, so how would you say the Canadian investor base has responded to the record supply in your market?

PD: So the Bank of Canada has started to cut rates, albeit, I think, much later than anticipated, like in the U.S., as you just highlighted, and I think we were anticipating, the path of rates and cuts eventually becoming a much more pronounced tailwind to fund flows and the amount of money that investors had to invest at the beginning of the year than what ultimately prevailed.

That being said, I think the amount of supply that’s come through the market while it was record setting and while it did put some pressure on the market at some points, I think was ultimately really well received, all else being equal. I think that’s evidenced by some of the kind of hard facts in terms of the supply that came through.

For instance, we saw the largest ever corporate bond offering in our market at $7.15 billion price in mid-June, and that was across 11 tranches and saw north of 100 discreet investors. So, I think that is representative of a very healthy functioning market, despite it being at the tail end of that $85 billion.

And so, I think, again, we were setting ourselves up pretty well for the second half of the year. I think there’s still a lot to be said around the path of rates and when we’re going to see subsequent cuts. I think some of those secondary impacts that you were referring to in terms of why central banks are cutting and maybe negative implications for credit, I think are also going to be critical for the second half of the year.

But I think we’ll learn more about that in the coming weeks and months here as we get more data to really dive into that, the rationale for some of those moves ultimately in the next little bit here.

Fadi, we’ve taken a, obviously a look back to what we’ve seen play out in the first half of the year from both the investor and the issuer perspective. Let’s look forward here, what are you expecting for the second half of the year for issuance in the U.S. market, and what do you think is going to drive that activity?

FA: So, I think the second half is going to start to show a slight fade as far as the ferocity of issuance that we've experienced during the first half.

As I mentioned earlier, we finished up the first half of $900 billion of supply. We’re expecting another $450 billion of supply for the second half of the year which will actually take us to $1.35 trillion, which is slightly higher than what we were forecasting at the beginning of the year, which was $1.25 trillion. Why do we think that's going to be more activity than what we were anticipating at the beginning of the year? I think couple of factors would drive this. One, financials have been incredibly active throughout this year. Much more active than last year’s same period, just simply because financials were, particularly banks, were dormant after the Silicon Valley crisis, where they just dialed back a lot of their funding, given the market volatility.

So, on face value, it seems like the financial sector is way ahead of expectations. But, in reality, it’s operating at a normalized fashion as you look at it on a historical basis. I do think the multi-year tights across different sectors and, you know, spreads being where they are today will encourage more and more issuance out of the financial sector as we get into the second half.

And that’s likely to take place across the capital stack, whether it’s senior funding, we’re starting to see a lot more subordinated funding. Where it's becoming more and more competitive for financial institutions to effectively recapitalize their balance sheets and take advantage of this competitive environment for them.

And financial institutions tend to gauge the quality of the funding for them in the market on a spread basis. So, this is a very attractive opportunity for them. I do think that certain segments of the corporate space are also going to be pretty active as we get deeper into the second half.

M&A is a very big theme in the U.S., we’re expecting more and more M&A across different corporate sectors. I do think that the M&A activity, most of it will be funded in the debt capital markets just given the competitive nature of being able to access a significant amount of liquidity in the debt capital markets.

So that’s likely to buffer up the supply dynamics in the corporate space. We’re also expecting an increase in capex, and a lot of this capex is going to be funded in the fixed income market, particularly in the P&U space, and in certain segments in the industrial space. And that’s just been driven by the need for a lot of these companies to expand their ability to upgrade their generation capacity and to be able to align and meet the expectations down the line that's driven by the need for more data centers. And that's coming through electrification. That's coming through the resurgence in focus on AI and other aspects of the economy. And so, that's likely to put further sort of funding need within these industrial segments and P&U, aside from the upcoming maturities that need to be rolled over.

I do think there's certain segments of the corporate space which will not necessarily be significantly present during the second half, and I think particularly consumer retail, I think TMT, those are likely to tail off a little bit as we get into the second half. Just simply driven by the fact that all in cost of funding as you look at coupons, still historically high, and a lot of these companies are effectively awash with cash and don't necessarily need to crystallize these coupons as of yet.

If we do see a drop in rates and a drop-in all-in cost of funding, it might encourage some of these companies to step into the market. But I think if we assume that the current environment is going to continue to play out in terms of rates and all in costs. I think you should expect TMT and consumer retail to be less active in the second half.

So, Patrick, what are you seeing in Canada?

PD: So, we revised our forecast upward, similar to what you did as well in the U.S., Fadi, to $130 billion. That’s upwards of $15 billion higher than what we set out at the beginning of the year. And ironically, that's leaving $45 billion for the year, for the second half of the year, a tenth of the size that you're anticipating in the U.S. markets which I think contrasts the scale of both of our markets.

 A few observations in terms of where we're going to see that supply come from: I think financials are going to continue to be active in our market. We've seen the Canadian banks be a little bit less active than what we were, have historically seen, but I think that they should continue to be relatively active in the second half of the year.

And then among corporates, I think there’s still going to be continued needs for upcoming maturities. And then I think to your point on capex, I think we're going to have some of those similar dynamics here in Canada with energy, pipeline, midstream companies, as well as power and utility companies, all active.

I think as you think about what drove supply in the first half of the year and whether or not that's going to translate into continued supply in the second half of the year, I think there's a key question mark on that deposit opportunity that I spoke about and whether or not the shape of the curve is going to allow for corporates to ultimately take advantage of that dynamic.

And I think the timing of all that issuance as well and potentially continuing to avoid the U.S. election will continue to drive the timing decisions that issuers are facing in the market.

FA: So, Patrick, what are you keying on in terms of second half of the year when it comes to opportunities and strategies that you would recommend for the borrowers?

PD: I’m going to let you cover off the U.S. Election, Fadi, because you’re the subject expert on that in the room here, but I do think that's obviously going to impact the markets globally. I think, first and foremost, we're expecting, net supply for the second half of the year to be very constructive for credit spread.

So, there's $65 billion roughly of reflows, so coupons, maturities being paid back into investors hands, relative to the $45 billion of new issue supply that we're anticipating for the second half. So, I think that will be supportive of credit spreads. I don't think it's always going to be smooth sailing from a macro perspective, so I do think that borrowers are going to continue to need to be agile as they think about the windows of opportunity for them to hit, and ultimately look for those windows to really lock in, I think, attractive underlying rates.

And we’ve seen the market in terms of the underlying Government of Canada rate market, continue to be very volatile. And so, to the extent that borrowers can either lock in or accelerate funding to take advantage of that to create a more compelling coupon. I think they should obviously take that opportunity.

And then finally, I think as you pointed out, there's opportunities in the U.S. market for Canadian borrowers to take advantage of that foreign demand. There’s obviously going to be opportunities for global corporates to look at the Canadian market in light of the differential in terms of interest rates between the U.S. and Canada whereby all in rates are lower in Canada. So, I think just being nimble as it relates to what currencies you're looking at is also going to be a critical input I think for borrowers to navigate in the second half of the year.

So, Fadi, in light of that, U.S. Election, potential for volatility, what are you telling borrowers that you're speaking to in terms of how to navigate the market in the second half of the year?

FA: Patrick, I think the market’s narrative is generally aligned in that government spending will continue to be elevated regardless of who wins the elections in the U.S. in November. I do think that there's going to be a bigger impact if we end up in a, sweep outcome where one party controls both the White House and Congress, that's likely to put further pressure on rates moving higher as, you know, the party that controls is able to pass through more policies that could be impactful for rates.

So how can borrowers navigate through this? I think a recommendation is clearly that they should not wait until the elections to fund their needs that are remaining for this year or even funding needs for 2025. We do think that the slowdown in issuance that we're anticipating in the second half versus the first half is going to be constructive for spreads.

So that, I think that, represents an interesting opportunity for borrowers to fund, ahead of what could potentially be some rates and macro volatility on the back of the elections. They can achieve that through multiple ways that can include reopening’s of recent benchmarks or access the floating rate market, which has shown deeper access for issuers who have not been able to access it for size throughout the beginning of this year.

We also think that prefunding early for 2025 maturities is not as penaltive. Simply, just given how the curve is inverted and issuers are able to borrow today and effectively park proceeds into government bills or deposits and effectively chip away that negative carry, and in some instances, it's actually positive carry for some of the big corporations.

And I would lastly also highlight the opportunity in the, in the junior subordinated segment of the market where it could be available in an efficient way for both corporates and financials, investors in this current environment, feel very comfortable with risk, and that is creating a very competitive access point for borrowers in the subordinated market. So that could be an opportunity for them to raise equity like funding at a much more competitive rate than other markets.

PD: So, lots to be mindful of for the second half of the year and a lot to chew on if you're a listener here. But I think we always appreciate getting your insights, Fadi, on the U.S. market. Always insightful. We're looking forward to doing the next one with you.

FA: Lots of opportunities and lots of challenges to go through, Patrick, and it's always a pleasure. Look forward to the next one.

Announcer: Thanks for listening to Scotiabank Market Points. Be sure to follow the show on your favourite podcast platform. And you can find more thought leading content on our website at gbm.scotiabank.com