Key Drivers for the Quarter
- As the world adjusted to the economic effects of COVID-19, market actions in March rivaling those experienced during the global financial crisis (GFC) dominated U.S. investment grade (IG) corporate bond market performance in the first quarter.
- Corporate earnings and economic growth projections were materially lower due to demand destruction caused by social distancing and quarantine strategies aimed at controlling spread of the virus.
- Market sentiment turned more positive at quarter end due to massive policy responses from the Fed and Congress.
- From a market technical perspective, IG corporate supply was a record high. Issuers sought to close short-term debt by issuing new bonds at still-favorable financing rates. IG bond fund flows were sharply negative in March.
Adjusting to post-COVID expectations.
We opened our year-end IG corporate bond market review by noting that 2019 delivered its highest total return in a decade (14.5 percent, per Barclays). Considering that, it seemed to us that 2020 might be a market more suited for clipping coupons than capturing significant further upside. Spreads were below 100 basis points (bps). Interest rates appeared rangebound. A reasonable expectation was for IG corporates to generate modestly positive total and excess returns in 2020.
Reasonable expectations were redefined by the social and economic retreats that COVID-19 forced on worldwide markets. While economic growth was on solid footing as late as February, for the balance of 2020 the economic outlook will be shaped largely by the ability of the medical community to arrest spread of COVID-19 and develop effective therapeutics to treat those who are infected. U.S. GDP is expected to show a modest decline in Q1 and turn materially negative in Q2 as effects of the coronavirus impact demand.
The Fed and Congress have responded to the market turmoil in greater measure and more quickly than during the GFC in 2007-2008. The dimensions of demand destruction will vary across industries, but stimulative policies and low global interest rates should be supportive of longer-term corporate performance after a wrenching adjustment.
On March 17, 2020, the Fed announced actions that we consider to be strengths for corporate bonds (See our 1Q20 Corporate Trends Dashboard at the end of this update). It reinstituted the GFC-era Zero Lower Bounds federal funds interest rate policy and reset the current fed funds rate range to 0 to 25bps in March.
The Fed also relaunched a Commercial Paper Funding Facility (CPFF) through which it will buy 3-month bonds from companies with strong credit ratings to help those firms retain workers and handle operating costs. The Fed also will purchase IG bonds with maturities of 5 years or less directly from issuers through the Primary Market Corporate Credit Facility (PMCCF) or in secondary markets through the Secondary Market Corporate Credit Facility (SMCCF). Also, the Fed will make loans to corporations secured by collateral. Details on monetary and fiscal responses are provided later in this review.
While the Fed is supportive, corporate profits and balance sheets are clearly at risk. We expect credit downgrades by the rating agencies, which is common during recessions.
Profits likely to fall, leverage likely to rise.
Earnings growth is expected to be negative 11 percent year-over-year in Q1 and then materially negative in Q2 as the coronavirus sharply reduces economic demand, per Bloomberg, based on consensus estimates for the S&P 500 Index.
Looking back at prior market shocks may provide context for current conditions. Corporate debt leverage increased in past periods of economic contraction, as earnings before interest, taxes, depreciation and amortization (EBITDA) tend to drop faster than debt obligations.
Looking at the past three U.S. recessions, we observe that average leverage moved up 0.5 times, peak-to-trough. Assuming a 25 percent decline in EBITDA and a 5 percent rise in debt in FY 2020, leverage may move from 3.0 times at FY 2019 to 4.25 times at FY 2020. Presuming economic recovery in FY 2021, leverage may decline on modest debt reduction and EBITDA growth.
Balance sheets will be a focus for corporations.
U.S. corporate cash flow is expected to decline in FY 2020 due to reduced demand. Issuers can take steps to mitigate the potential for financial stress to negatively affect their credit ratings. For example, reductions in capital expenditures (capex), halts on share buybacks and some dividend cuts can be partial offsets for preserving liquidity and financial strength.
Ratings downgrades seem likely, but IG default risk remains low, in our view.
As they adjust their economic and sector outlooks, rating agencies have begun to downgrade IG issuers, consistent with prior periods of contraction. Moody’s Investors Service revised its outlook on the U.S. IG corporate market from stable to negative in March 2020, implying continued pressure on agency credit ratings.
Rating agency downgrades historically spike higher in periods of economic contraction. We expect this period will be no different. According to CreditSights, year-to-date U.S. IG corporate credit downgrades occurred across the quality spectrum. In March alone, $235 billion of corporate debt from 32 U.S. IG issuers was downgraded and migrated across rating tiers − three times the amount of debt and number of issuers downgraded in February 2020. Barclays reported that March 2020 saw the highest monthly volume ever of fallen angels − downgrades from IG to speculative grade.
Supply-demand trends may remain unbalanced.
Technical trends in the IG corporate bond market during the first quarter were negative. Investor sentiment caused high redemption levels in IG funds, driving negative flows. Meanwhile, IG supply ran at a record clip as issuers sought to raise cash to close out commercial paper debt.
IG mutual funds saw net outflows for the quarter, marking three consecutive weeks during March of record outflows, per ICI. Heavy IG corporate supply was $519 billion in the quarter, up by 50 percent year-over-year, per Bloomberg estimates.
During the last full week of March, the market saw record-high IG corporate supply with $110 billion pricing, according to Bloomberg. The fact that the market could still price that volume of deals demonstrates the breadth and diversity of the IG buyer base. The insurance industry and other nontraditional buyers, including a strong foreign bid, helped drive demand.
IG spreads reached post-crisis wides in March.
By the end of the first quarter, IG corporate bond spreads were 272bps, up from 93bps at year-end 2019. Not surprisingly, spread widening varied across the quality spectrum, showing favor to higher-rated issues.
Spreads for bonds rated AAA, AA and A widened by 70bps, 114bps and 141bps, respectively, during the first quarter, while spreads for BBB-rated bonds were 232bps wider, as shown in the chart IG Corporate Spread History.
Flatter, briefly inverted credit curves in March.
Corporate bonds with maturities of 10 years and longer typically offer higher spreads than bonds with 1- to 5-year maturities. The slope of the credit curve is normally positive, reflecting added compensation for credit and rates risk.
Liquidity stress in short-term markets during the first quarter pushed spreads on 1- to 5-year bonds above those of bonds at 10 years and longer. The condition created opportunities to purchase intermediate maturity bonds at more attractive valuations than in recent history.
Considering ESG in the Time of Coronavirus.
The COVID-19 pandemic presents financial and operational challenges for corporate bond issuers. Integrating key environmental, social and governance (ESG) factors into credit quality assessments can provide valuable insights, especially during times of stress.
The decisions made by corporate leaders as overseen by their Board of Directors may reveal important information about preparedness and resiliency in the near term, and commitment to sustainable operations over the long term.
We view fiscal stimulus provided through the Coronavirus Aid, Relief, and Economic Security (CARES) Act in combination with Fed conduits for monetary support (e.g. PMCCF, SMCCF, CPFF) as positive for IG corporate bonds. The portion of aid earmarked for corporates is $500 billion. Of that, $25 billion is carved out for airlines and $17 billion is for businesses deemed critical for maintaining national security, which may include defense firms.
In our view, term restrictions on loans may mean the fiscal stimulus may be more geared toward and helpful for businesses with weaker access to capital, such as speculative grade issuers and small to midsized enterprises. Collateralized Fed loans may be a better fit for high yield companies, since fewer of them pay dividends or buy back stock. Because bank lines are typically secured − unlike IG companies, which are usually unsecured − they may be a better fit for speculative grade issuers.
Credit Trends Dashboard
In our 1Q20 Corporate Trends Dashboard, we capture our views of key drivers during 2020 of IG corporate credit including fiscal/monetary stimulus and attractive valuations as offset by a weak economy and operating trends.
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