Photographer: Naashon Zalk/Bloomberg News

Does the Corporate Bond Market Have a ‘FANG’ Problem?

Bigger may not necessarily be better in bonds.

A handful of dominant stocks were responsible for rescuing the U.S. equities market last year.

The ability of Facebook Inc., Inc., Netflix Inc., and Google Inc. (now Alphabet Inc.)—known as ‘FANG’—to continue carrying America’s equities on their collective shoulders has come under intense scrutiny in recent weeks as investors ponder whether the U.S. bull market of the past six years is beginning to look a little long in the tooth.

A similar trend can be seen in the corporate bond market where companies sell their debt, with the average size of new investment-grade bonds reaching $793 million in 2015, up 12 percent from the prior year and the highest level since at least 2006, according to estimates from Bank of America Corp. The growing weight of larger bond sales (and the expanding heft of the big investors who snap them up) has some analysts concerned about the market's resiliency in the face of rising defaults.

Source: BofAML

“What is so ironic is that in the equity market is you end up with investors falling in love with the largest cap names and momentum builds momentum,” said Peter Atwater, president of Financial Insyghts and formerly a senior banker at JPMorgan Chase & Co. “In the fixed-income market, bond investors must love the most indebted companies. The more debt a company can issue, the more their debt must be bought.”

On Wednesday, AB Inbev sold $46 billion worth of bonds in the first slug of new issuance in a corporate debt deal that is expected to become the largest on record. It is the continuation of a trend that has seen the size of new bond issues grow markedly while the total number of debt sales declines, as analysts from Goldman Sachs, Bank of America, and CreditSights have been noting in recent days. By the latter’s estimates, bond sales over the $5 billion mark added $400 billion to total new issuance volume in 2015, or double the $184 billion added in 2014.

Investors have been rushing to snap up 'super-sized' bonds thanks partially to their perceived ability to circumvent liquidity issues in the market. BofAML analysts led by Hans Mikkelsen noted on Wednesday that trading turnover —a crude way to measure ease of trading—in larger bond tranches was some 70 percent higher than for smaller debt slices.

Source: BofAML

But the growing dominance of large bond deals may also mean that the market is more vulnerable should certain corporate names come under pressure. In that situation, credit ratings downgrades and big price drops of companies with a large amount of outstanding issuance could have a corresponding effect on overall bond market returns and indexes.

Those worries are gaining new urgency as investors fret over the possible turning of the credit cycle—a development which would entail an increase in the corporate default rate from its current historically-low level.

"An ideal scenario in a world of rising idiosyncratic risk (should such a thing exist) would be to have a market where issuer weights are broadly equal," BofAML analysts led by Barnaby Martin said in a note on Thursday. "Poor credit selection would still be frustrating for investors, but the effect on the overall index would not be as outsized."

Source: BofA

Their analysis shows the dominance of issuers in the market for bonds sold by junk-rated and investment-grade European companies has been growing in recent years, with the trend most pronounced in the energy sector.

The tendency of investors to chase big bond sales "encourages blockbuster deals and buybacks because there is guaranteed demand for the debt so long as you can get an investment-grade rating," said Atwater.

"Talk about a perverse system," he added.

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