The credit cycle has been extended by central bank policies that enable high corporate borrowing at very low interest rates.
Q4 Corporate Market Review
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today, I am joined by Nick Elfner, director of corporate bond research here at Breckinridge. Nick is also a member of our Investment Committee. Today we will review corporate market performance for the fourth quarter of 2016 and discuss our current investment outlook. So Nick, before we get into a review of market returns and credit trends can you quickly summarize our investment outlook for the investment grade corporate bond market?
Sure. So we think the investment outlook for the corporate bond market is unusually uncertain. For the first time in eight years, the U.S. has a new president, administration and policy platform. We see positive catalysts in the corporate market primarily related to potential corporate tax cuts, cash repatriation and deregulation. The possibility of tariffs, trade disputes and geopolitical risks are negative outcomes particularly for large U.S. exporters. And while corporate leverage is very high, potential policy, regulatory and fiscal adjustments may extend the economic and credit cycle by year or two. Therefore, we do not expect a recession over the next 12 to 18 months and believe corporate credit can perform relatively well.
I see, so what did investment grade corporate spreads do in the fourth quarter and for the full year 2016?
So, intermediate IG corporate spreads narrowed 8 bps in Q4 to an average spread of 104 bps. That is the tightest level since May 2015. BBB spreads narrowed 21 bps in Q4 compared to AA and A rated bonds which tightened by 8 bps and 12 bps respectively. So for 2016, corporate spreads were an impressive 35 bps tighter and BBB spreads tightened 78 bps, and we would note that the quality spread between AA rated and BBB rated corporate bonds ended the year at 80 bps, which is its tightest level since October 2014.
Got it. So Q4 was an interesting three months for corporates. Can you give us some performance details?
Based on the 75 to 85 bps back up, and five and seven year U.S. Treasury yields respectively, the total return for the intermediate IG corporate market was -1.95% in Q4, according to Barclay's. However, compared duration neutral Treasuries and based on higher carry and spread compression the corporate market still generated a solid 69 bps of excess return in Q4.
Building on that, what sectors outperformed and then which ones underperformed?
For the third quarter in a row the energy sector outperformed the corporate index. Energy had an excess return of 1.75% beating the index by 106 bps in Q4. Energy issuers benefited from sustained oil price stability brought on by announced OPEC production cuts among other factors. Financial sectors including finance, rates, insurance and banking issuers outperformed due to the move higher in interest rates in Q4, which is expected to benefit interest and investment income. And lastly, the communications sector underperformed the corporate market by 73 bps in Q4 on M&A activity and expected bond supply.
Okay, so shifting gears now, merger activity driving new bond issuance was a big theme in 2016. Can you share some quarterly and year-end M&A and supply figures with us?
Sure. So corporate issuance of $230 billion in Q4 was 15% lower year over year. The sharp move higher in rates and elevated volatility contributed to a slightly less favorable primary market. However, for the full year, IG corporate issuance of $1.35 trillion was slightly above a record 2015 as low interest rates continue to encourage record level borrowing. U.S. M&A volume was $700 billion in Q4 that was down 22% year-over-year. This deceleration reflected elevated valuations, increased antitrust scrutiny, and global economic uncertainty. For the full year M&A was down 18% to $2.3 trillion dollars.
Interesting. So what about demand indicators? How did bond fund flows hold up in the fourth quarter?
Demand indicators for IG corporates generally remains solid. Taxable bond and exchange traded bond funds reported net inflows of $23 billion in Q4. For 2016, taxable bond funds had inflows of $162 billion including $84 billion going into IG funds. It remains to be seen whether or not fund flows, an important source of demand for taxable bonds, can remain healthy, given the Fed is expected to further lift short-term interest rates in 2017.
And what about foreign demand which has been a key driver, has that been strong also?
Yes, purchases by foreign residents of corporate and foreign bonds have also been strong. Through the third quarter, foreigners bought almost $400 billion of U.S. corporate and foreign bonds at a seasonally adjusted annual rate per Fed data.
I see, and what about insurers and banks? How has demand held up from that side?
So financial institutions are important buyers of IG corporates and other bonds. U.S. insurers and commercial banks hold over $6 trillion of bonds. This ownership provides a steady source of demand for bonds through reinvestment of coupon income and funds for maturities. Assuming an average coupon of 3%, and that 3% of bonds mature each year, would equate to nearly $400 billion available funds for reinvestment annually. That creates a potent source of steady demand for IG corporates and other high-quality bonds.
Okay, so we shifted three key drivers in the dashboard in Q4. Can you give us some detail on that?
Sure, so in our credit trends dashboard, we capture key drivers of IG corporate credit, and our view of incremental shifts in these drivers from quarter to quarter. First, we downgraded our assessment of central-bank accommodation from moderate strength to neutral. We expect three Fed rate hikes in 2017 and a moderate pace of policy tightening. Fed policy is no longer a tailwind for corporate credit. Second, we upgraded our assessment of corporate profits from modest weakness to neutral. S&P 500 earnings beat forecasts in Q3 growing 2.9% year-over-year. Solid profit growth is forecast in 2017 because of potential tax reform, easier comparables, and a resurgent financial sector. And lastly, we upgraded our assessment of oil and commodities from a modest weakness to a neutral. Oil prices have responded positively to announced OPEC production cuts and a steady recovery in key commodity prices has stabilized energy in basic industry credits.
Okay, so can you highlight a couple strengths that are supportive of the corporate market?
So the prospect of improving net interest margins and profitability through the move higher in interest rates is buoying the U.S. bank and insurance sectors. This is a key strength, given that both are important issuers and providers of liquidity and demand in the corporate bond market. Net interest income is estimated to rise by over $10 billion for the four largest U.S. banks if rates rise by 1% per SEC filings. The consensus yield forecast presently calls for 50 bps increase in 10 year U.S. Treasury yields over the next 18 months. Second, as we discussed, S&P 500 companies appear positioned to report improved profit growth this year. Corporate tax reform and cash repatriation could improve earnings and slow debt growth. This could provide for some steadying of corporate credit fundamentals.
Okay, now where do we see weaknesses? What could negatively affect corporate credit?
Excessive shareholder rewards remain a credit concern. Buybacks and dividends for S&P 500 companies nearly doubled from 2010 through 2016 growing from $516 billion to about $1 trillion per FactSet. By contrast capital expenditures for this group grew by only about 50% over the same period. It’s this high borrowing to fund shareholder rewards and has sharply increased debt, and this has been accompanied by little additional cash generation services liabilities. Second, high shareholder rewards have driven financial leverage materially higher. Total debt has increased to nearly 50% of capital for S&P 500 non-financial companies and that is up from 40% five years ago, and median debt to EBITA moved about three times for U.S. IG credits to levels just above the 2008/2009 peak. IG industrial companies have never been as highly leveraged and are a thin cushion were an unexpected economic recession or crisis to emerge.
Right, so switching gears now from talking about some of the strengths and weaknesses, you mentioned uncertainty earlier in light of potential tax reform and policy changes. What sectors does our research team see as potentially positively impacted from a credit perspective?
So President Trump’s victory has potential credit repercussions for a number of corporate sectors. Implications may initially be positive for financial companies but more mixed for industrials. The president has proposed cutting corporate tax rates, eliminating the tax deductibility of interest, and implementing a one-time tax holiday to repatriate overseas corporate earnings cash. These measures will be positive for after-tax earnings and could increase the cash coffers of multinational corporations that repatriate overseas monies thus slowing debt issuance over time. President Trump and some Republicans have proposed repealing the Dodd-Frank Act. This could cause regulatory oversight compliance and risk management costs to decline for banks and insurers. While this could support earnings near-term, longer-term this could create more credit risk by allowing banks and insurers to take greater risks and have thinner capital cushions. Larger energy companies could benefit from a new energy plan from Trump that would roll back subsidies on renewable energy projects and allow for greater investment in pipelines and fossil fuels. Additionally, potentially less stringent environmental regulations could allow for expanded drilling opportunities and finally on the construction side, President Trump has discussed increasing infrastructure investment which could be positive for construction machinery firms.
Got it. So what, if any, corporate sectors do we see as possibly negatively impacted by some of these policy changes?
So the president has indicated a desire to renegotiate trade agreements and potentially levy tariffs or institute border taxes. A tariff could prompt the U.S. dollar to rise natively impacting U.S. exporters. A border adjusted tax could also negatively impact retail, auto or other sectors where goods are imported to be sold in the U.S. A new administration could repeal the affordable care act. This could impact some pharmaceutical credits as more than 20 million Americans could lose healthcare potentially. We do expect a more favorable regulatory environment for businesses but rhetoric suggests less patience for extraordinarily high drug prices. On the defense side, the president has called for eliminating the defense sequester, which may be positive for some defense companies. However, recent comments indicate some concern over high-cost military programs. But overall, we think the companies we invest in are highly creditworthy and remain well positioned to weather changing U.S. and global political landscapes.
Okay, great. And what about valuations. What are our thoughts on corporate yield spreads?
Well at current valuations, IG corporate spreads are slightly tighter than their long-term median which is about 120 bps over Treasuries excluding periods of U.S. economic recession, IG corporate spreads are close to their post financial crisis tights, but demand remained strong and we expect spreads to be range-bound in 2017.
And finally, to wrap things up. What is our current strategy for corporate bond investing here at Breckinridge?
So in today's uncertain and potentially volatile near-term environment our strategy for corporate bond investing is to focus on the longer term. We believe that management of large global corporations should emphasize long-term strategy and try not to be swayed by the winds of political change which may be fickle and short-lived. We continue to concentrate on investing in the bonds of high quality companies that have meaningful leverage or credit ratings targets, conservative financial philosophies, and established commitment to innovation and favorable ESG profiles. I think I will leave it at that, Natalie.
Great, well thank you so much. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast. Thank you.
DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.