2013 was a comeback year for the capital markets. While interest rates experienced periods of volatility in the second half, the capital markets digested this volatility and remained open and accessible at attractive levels. This momentum is carrying into 2014, and provides reason to be optimistic about the health of the capital markets this year.
In particular, the capital markets have two major advantages in their favor this year. First and foremost, the Fed has finally begun tapering its asset purchases, letting the markets digest the “actual” change in the supply/demand of the market rather than the “potential” change based on differing expectations. The Fed’s pace of reducing its purchases can still create volatility, but now that the process has started, it’s much easier for the market to understand empirically how the stimulus reduction will affect interest rates.
Another major difference from last year is that fiscal policy risk is more muted. A year ago, the markets were staring at a potential government shutdown due to the raising of the debt ceiling as well as the unknown impact of budget cuts required by the sequester. With the Senate passing the sequester-relief budget plan in early December, issues surrounding the sequester have been pushed out to 2015. The debt ceiling debate will heat back up in February, but given Congress’ loss of political capital from the recent government shutdown, the general hope is that the risks of continued brinkmanship will speed resolution.
With significantly more transparency around the Fed’s stimulus exit and fiscal policy, interest rates are poised to continue their upward trajectory in 2014, but in a less volatile fashion than in 2013. Even if rates sharply rise or drop, these outlier scenarios are very manageable based on the strength of the capital markets. For instance, the main impetus for a dramatic increase in rates would be a major improvement in the economy, which would be a welcome scenario for all industries. And the probability of a negative shock, such as a double-dip recession, diminishes with each day that economic recovery continues.
The above interest rate commentary focuses mostly on the longer end of the yield curve (10 year+), while the shorter end of the yield curve looks to remain at historic lows. The Fed has explicitly stated its strategy of keeping monetary policy highly accommodative with the federal funds rate remaining at near zero “well past the time that the unemployment rate drops below 6.5 percent.” The Fed has built significant credibility through its actions during the recession as well as in its continued support of the economy post-recession. Based on this credibility and its stated timeline, I believe that we can expect the short end of the yield curve to remain anchored at historic lows throughout 2014.
More specifically, here’s a look at what to expect in 2014 for the portions of the capital markets that affect Kimco.
Mortgage market
All aspects of the mortgage market — including bank balance sheet loans, insurance company loans, and CMBS — continue to be healthy. U.S. depository institutions are currently sitting on more deposits than ever (deposits surged 40 percent from September 2008 through September 2013, to $9.57 trillion). This swell of deposits is causing banks to lend money to high-quality sponsors at aggressive leverage and spread levels. Couple tight bank spreads with Libor anchored at sub-20 bps, and the result is a floating rate mortgage market that continues to produce yields at century lows.
Insurance companies have always taken a more conservative lending approach, and have an embedded need to match their long-term policy liabilities with safe, long-term investments. They continue to increase allocations to the mortgage market and will provide a strong base for mortgage needs throughout any portion of the economic cycle.
Lastly, the CMBS market ended another great year in which it weathered multiple spats of volatility in interest rates, while doubling its total volume to just under $100 billion in 2013. The CMBS market increases its viability and probability of being a source of reliable mortgage capital every year that it can withstand periods of volatility without significantly impacting the demand from securitization investors.
Investment-grade bond market
The investment-grade bond market set new records in 2013 with approximately $1 trillion in new issuance. Initial volume predictions for 2014 are slightly below the levels of 2013, but remain historically high. Interest rate risk management was a main theme for 2013, where issuers took advantage of low coupons to push out maturity profiles. As interest rates continue to rise, the drop-off in interest-rate-risk-management-driven issuance will likely be offset by event-driven transactions, which will pick up as the economy continues to improve and show further signs of stability.
Credit spreads remained stable throughout 2013. This seems incongruent given the historically high amount of supply. But the key is that the majority of the issuances were refinances, thus the overall net issuance in 2013 was only a little over 20 percent of the total, record new issuance.*
There will likely continue to be a lot of new issuance in 2014 that supports a highly liquid and price-transparent bond market with very little net new supply. This is a positive trend for issuers because the lack of net new supply will allow spreads to compress in a partial offset to rising base interest rates, while a highly liquid market gives companies clear and accurate price discovery as to where new issuances will execute.
Unsecured bank market
High deposit levels drive very competitive spreads on all bank lending products, and will continue to drive attractive credit spreads on unsecured revolvers and term loans. Basel III and Dodd Frank compliance requirements and their associated costs are coming down the pike. Many lenders will feel pressure to pass these costs to borrowers, but the compliance-driven pricing pressure will be more than offset by the need for U.S. lenders to put their money to work, given their high deposit levels. But the trajectory of spread compression in this market is likely to slow in 2014 from significant tightening to a more modest compression.
Perpetual preferred equity market
Issuance in the corporate perpetual preferred equity market in 2013 was down about 30 percent from 2012 due mostly to slowing of issuance in the second half of the year as interest rates were volatile and increasing significantly on the longer end of the yield curve. Perpetual preferred equity is seen by most corporate issuers as a permanent component of their capital structure that does not need to be continually replaced or refinanced given the lack of a maturity date. Thus, all in coupons are the main driving force behind issuance, as opposed to spreads or a maturity date.
Perpetual preferred equity has no maturity, and pricing is driven by the outlook on the longest portion of the yield curve. This portion of the yield curve has increased the most over the last year. As a result, the PP equity market feels the effects of 1) corporate issuers being more reluctant to issue, as all in coupons have risen significantly, and 2) perpetual preferred equity investors are more reluctant to make significant investments given the likelihood that rates on the long end of the curve will continue to rise.
Overall, 2014 is set to be a vibrant year for the capital markets even with a backdrop of modestly increasing interest rates. The health and liquidity that is applicable for all facets of the capital markets will allow for modest spread compression, which partially offsets the likely rise in interest rates. All in all, borrowing costs will likely rise, but only modestly given the capacity for spread compression throughout 2014.
*Source: Deutsche Bank 2013 Year in Review and 2014 Outlook Report
The statements in this post, including targets and assumptions, state the Company’s and management’s hopes, intentions, beliefs, expectations or projections of the future and are forward-looking statements. It is important to note that the Company’s actual results could differ materially from those projected in such forward-looking statements. Factors that could cause actual results to differ materially from current expectations include the key assumptions contained within this post, general economic conditions, local real estate conditions, increases in interest rates, foreign currency exchange rates, increases in operating costs and real estate taxes. Additional information concerning factors that could cause actual results to differ materially from those forward-looking statements is contained from time to time in the Company’s SEC filings, including but not limited to the Company’s report on Form 10-K. Copies of each filing may be obtained from the Company or the SEC.
