On June 7, Banco Santander SA announced its acquisition of Banco Popular Español for €1 following a deterioration in Popular’s liquidity position and concerns about Popular’s ability to raise further capital.
Corporate Bond Market Outlook Q1 2018
Key Drivers for the Quarter
- After years of sluggishness, stronger top-line growth reflects improved demand and synchronized global growth. Proposed tariffs are a key risk.
- U.S. bank capital remains a key strength. While industrial company leverage is near a record high, solid earnings, tax reform and repatriation may slow increases.
- With increased volatility in equities, rates and credit, new IG debt issuance declined in 1Q18, and completed mergers and acquisitions (M&A) also dropped.
- While cash repatriation enhances management and financial flexibility, it may also raise event risk and increase focus on short-term shareholder enhancements.
- Cybersecurity, data privacy, antitrust cases and other reputational and ESG risks are increasingly prevalent.
A One-Handed Credit Analyst
President Harry Truman famously demanded, “Give me a one-handed economist. All my economists say, ‘on the one hand ... on the other.’” Today, it seems the same could be said about credit analysts. On the one hand, economic growth is sound, corporate profits are strong, tax and regulatory policies are seemingly company-friendly and the banking system is healthy. On the other hand, the Federal Reserve is raising short-term interest rates, credit-negative event risk has continued, industrial company leverage is at a record level, geopolitical risks are high and ESG risks are increasingly prevalent. On balance, we think the risks are tilting to “the other” hand, which has informed our more defensive, higher-quality positioning within the investment-grade (IG) corporate bond market, relative to the benchmark.
Growth, Flows and Downgrade Risk
The U.S. economy grew by a solid 2.9 percent in 4Q17. Job numbers remain healthy, unemployment is low and consumer confidence is robust, albeit off its highs. While inflation data continues to disappoint, we expect the Fed to raise rates two more times in 2018 as monetary policy is normalized. In terms of flows, IG bond fund flows remain healthy while foreign flows have slowed. At S&P, potential corporate downgrades (e.g. issuers with negative outlooks or ratings on CreditWatch with negative implications) numbered 526 in 1Q18, exceeding 339 potential credit upgrades, forming a negative bias to potential actions.
Possible Tariffs, a Credit-Negative
To provide perspective on the estimated impact of possible tariffs on IG corporates, we note that the U.S. exported about $130 billion of goods to China in 2017. U.S. exports to China are concentrated in industries including aerospace, agricultural machinery, automotive, chemicals and food/beverage, among others. A potential 25 percent tax could be levied on goods within these industries. China has become a more important source of demand, and tariffs would likely be credit-negative for certain credits. Tariffs would be expected to adversely impact sales into China and could disrupt supply chains, although the U.S., Europe, Japan, Latin America and emerging markets remain important end-markets as well. We would expect companies with significant sales into China to address this risk in first-quarter earnings statements or SEC regulatory filings.
Strength: Positive Earnings Growth Across Most Sectors
A Tailwind for Credit
S&P 500 companies reported growth in sales and operating earnings of 5.5 percent and 10.7 percent, respectively, for 2017 (Figure 1). On an operating basis, all 11 S&P 500 Index GICS sectors reported year-over-year earnings growth and 10 out of 11 had positive sales growth. Profits have accelerated in recent quarters as global economic growth has picked up. After the profits “recession” in 2015 and 2016, companies have reported increasingly positive results. Consensus forecasts indicate double-digit growth for 2018 on lower tax rates and healthy economic growth. Strong earnings growth can drive improved financial flexibility if it is accompanied by a balanced capital allocation strategy.
Risk: Leverage Is Up, and Interest Coverage Is Down
A Headwind for Credit
Total debt-to-EBITDA for IG corporates has reached a record high and interest coverage has dropped (Figure 2). Gross leverage has risen to about 2.5 times for IG issuers, exceeding previous peaks in 2002 and 2009. Debt-funded share buybacks increase debt and reduce shareholders’ equity, boosting leverage. While industrial company leverage is at a record high, strong earnings, tax reform and cash repatriation may slow increases. However, tax reform and repatriated foreign cash could also spur increased merger activity and shareholder rewards. While completed M&A dropped, proposed M&A was up in 1Q18 with mergers across multiple sectors (e.g. Technology, Media, Insurance and Retail). While cash repatriation enhances management and financial flexibility, it may raise event risk and increase focus on short-term enhancements.
Technicals: Supply and Demand Both Declined
More or Less in Balance
With increased volatility in equities, rates and credit, IG supply declined in 1Q18 and completed M&A dropped with fewer merger-related bond deals (Figure 3). However, pending M&A has spiked higher and could spur future bond issuance. Gross IG fixed-rate new issue supply declined by about 15 percent in 1Q18 after the Tax Reform Act was passed and issuers rushed deals to market in 4Q17.
In terms of demand, inflows into IG bond funds were flat in 1Q18 but are healthy when viewed over the last 12-month period (Figure 4). Insurance sector purchases of corporate bonds has slowed but is a steady source of demand with a majority of the industry’s invested assets in fixed income. While still sizable, foreign purchases of corporates have decelerated as U.S. dollar hedging costs have risen. Repatriation appears to have weakened demand for front-end IG bonds, pushing spreads wider.
Summary: Sector Views
Divergence in Credit Fundamentals
Our research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and ESG drivers are evaluated through rigorous analysis. Our analyst sector outlooks and relative value assessments inform our Investment Committee as it formulates strategy and sets risk exposures for sectors within the corporate allocation of our Government Credit strategies. In the table below, our analysts have identified three corporate sectors with fundamentals that are stable to positive and two sectors with negative trends.
Given the Fed’s projected path, the length of the current expansion and high corporate leverage, our Investment Committee views the credit cycle as late stage and maintains a higher-quality bias across the corporate allocation within our Government Credit and Core Bond strategies. Within the corporate allocation, our Intermediate Government Credit composite is overweight Banking, Pharma/Health Care and Energy, and underweight the Transportation and REIT sectors. With the move wider in corporate spreads during 1Q18, valuations have improved for higher-quality credits as compared to where they stood at the end of 2017. This has created opportunity - particularly in the front end of the corporate bond market. However, quality spreads are still tight as compared to history, and there may be better entry points into lower-rated IG credit. Accordingly, given current valuations, we remain overweight AA- and A-rated corporates and underweight BBB-rated issuers within eligible strategies.
Credit Trends Dashboard
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.