New equity offerings can garner media buzz. Think of recent initial public offerings (IPOs) by Snapchat, Alibaba and Visa. Business media enthuse, investors clamor, and share prices often rise, at least initially.
The fixed income market equivalent – new bonds coming to market – seldom makes headlines. But new bond issuance may be much more consequential, at least for active investors pursuing alpha potential.
A bigger splash
The alpha potential available to active managers when new bonds come to market is significant for several reasons:
- New bond issues are a more frequent and much bigger share of the market. Over the past three years, newly issued bonds represented more than 20% of the capitalization of the U.S. corporate bond market, according to Barclays Point. In contrast, equity IPOs were less than 1% of U.S. equity market capitalization during the period, according to SIFMA and Bloomberg. This is logical because whereas common equity is typically a perpetual security, bonds have finite maturities.
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New bond issuance represents a consistent source of alpha potential. Active bond managers typically buy new issues when they come to market, often a week or more before the securities enter the index at the start of the month. This matters because new bonds tend to come to market at a slight discount (known as the new issue concession) to outstanding issues, hence the alpha potential active managers can access.
Yet passive managers sometimes wait to buy: They risk tracking error if prices move before the bonds join the index; managers also may face limits in how much off-index exposure they can hold. After all, the goal of passive managers is not to beat the index but to replicate and match its performance. - Active managers can pick and choose. Even though most new bonds come to market with a concession, active managers don’t necessarily buy them. PIMCO, as well as other firms with deep credit research teams, regularly pass on new deals they view as overpriced. Passive managers, by contrast, have an incentive to buy all bonds that enter the index, regardless of price.
