On October 14, new SEC rules governing money market funds (MMFs) will take effect. The rules are prompting a tectonic shift in the landscape for institutional prime MMFs.
Key Drivers for the Quarter
- Despite a mixed economic backdrop, the investment grade (IG) corporate market had a strong first quarter.
- Corporate spread widening in 4Q18 created attractive entry points during 1Q19.
- After a strong performance, IG valuations appear fair but steeper 5s10s credit curves present opportunities.
- From here, the credit outlook is trickier, as corporate profit growth slows and debt levels remain elevated.
- However, management teams are more focused on deleveraging as we sit today, and that is credit-positive.
It’s the Economy, Stupid
U.S. real GDP grew by 2.2 percent in 4Q18 – slowing, as expected, from over 3 percent growth in the prior two quarters. The Fed’s March dot plot revealed a dovish surprise, with the FOMC now expecting rates to remain on hold given lower projections for GDP and inflation. Pessimism over global manufacturing and growth concerns abroad influenced the Fed’s decisions.
On growth fears, the 3m10y spread turned negative in March, for the first time since 2007. The job market, inflation and the relative health of the economy underpin Fed monetary policy, the yield curve and, by extension, corporate bond markets. On the global front, China’s central bank cut rates and added stimulus, while the ECB has reduced growth expectations and added bank liquidity facilities. Economic growth has slowed in China and Japan, and Brexit looms as a key risk to markets.
A Mixed Credit Outlook
Despite a mixed economic backdrop, the IG corporate market had a strong first quarter with spreads finishing 34 basis points (bps) tighter after the risk-off period at the end of 2018, per Bloomberg. Spread widening in 4Q18 created attractive entry points during the first quarter and with pent up demand, spreads grinded in. From here, the credit outlook is trickier, as corporate profit growth slows, the yield curve flirts with inversion and debt levels remain high. But management teams are more focused on deleveraging as we sit today, and that is credit-positive. And, with the Fed on hold, the business cycle likely has further to run.
Fundamentals: Divergence in Sector Trends
Solid Operating Trends Offset by Negative Rating Trends
S&P 500 Index companies reported operating earnings growth of about 12 percent in the fourth quarter of 2018 year-over-year, marking the fifth straight quarter of double-digit growth, per Bloomberg. However, as the benefit of tax cuts rolls off, and as some economies slow and wages rise, operating trends are expected to moderate. S&P Global Ratings potential rating upgrades (e.g. issuers with positive outlooks or on CreditWatch with positive implications) numbered 332 in December 2018, lagging 535 of potential rating downgrades for a potential upgrade-downgrade ratio of 0.6:1. The current ratio is in-line with the 10-year average.
Strength: Banking Sector Fundamentals are Sound
The U.S. banking industry reported strong full-year 2018 net income of $237 billion, up 44 percent year-over-year, per FDIC data. Earnings power has improved post tax reform and low unemployment is driving solid credit trends. Profitability, as measured by return on equity, rose to 12 percent, allowing for solid internal capital generation. Credit quality, as measured by noncurrent assets to total assets, remains stable and healthy at about 0.6 percent. U.S. bank regulations are softening for regional banks, while oversight is still stringent for money center banks. While U.S. bank capital ratios are still solid, they are declining at the margin with rising shareholder rewards.
Risk: Some Progress on Industrial Deleveraging
IG gross debt leverage declined modestly in 2018 as EBITDA growth outpaced debt growth for most of the year, per Morgan Stanley. However, earnings growth is expected to materially slow in the first half of 2019 and that may delay further deleveraging.
Debt leverage is currently above its 20-year average in six out of 13 corporate sectors, per Bloomberg. Across the ratings buckets, AAs have added the least leverage in this cycle. In prior recessions, BBB-rated leverage peaked near 3 times while AA- and A-rated issuers remained below 2 times. Industrials’ gross debt leverage could move higher if an economic slowdown or recession emerges. High leverage is a concern, although we’d note that deleveraging is becoming more of a management focus.
Technicals: Net Supply and Foreign Demand Declines
Insurance and Fund Flows Remained Steady
In a major shift, net foreign purchases of U.S. corporate bonds declined to just $6 billion in 2018 as compared to $331 billion in 2017, per Fed data. However, insurance company and mutual fund flows remained steady. As an offset, net supply declined by 42 percent in 2018 on market volatility and elevated calls, tenders and maturities. As markets stabilized, supply recovered in 1Q19 with net debt issuance of $117 billion, per Barclays. Flows also picked up with a net $29 billion moving into IG funds, per ICI.
Valuations: Corporate Spreads Narrowed on a Dovish Fed
Spreads Snapped Back in 1Q19
Lower-quality IG corporates (e.g. BBB bonds) outperformed the broader market with spread tightening of 39bps in 1Q19, per Barclays. Average quality (e.g. A-rated) corporate spreads narrowed 29bps, while higher quality, AA-rated spreads tightened 23bps. From their respective wides over the last 12 months, BBBs retraced by 44bps, followed by single-As at 35bps and AAs at 30bps. In aggregate, at an average OAS of 119bps, the IG Corporate Index is back to November 2018 levels, prior to the sell-off. After the widening in the fourth quarter and the quick bounce-back narrowing in the first quarter, valuations appear fair but steeper 5s10s credit curves present opportunities.
Corporate Outlook: Sector Views
Divergence in Fundamentals
Our research analysts conduct sector scans for investment opportunities. In the table below, we have identified three corporate sectors with fundamentals that are stable to positive and three sectors with negative trends. Industry outlooks represent our expectation for the trajectory of sector fundamentals over the next 12-18 months.
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.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices.
Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.