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
- Earnings growth has slowed as the one-time benefit from the U.S. corporate tax cut begins to fade.
- With investors voicing concerns about high leverage, more companies are responding with debt reduction.
- Foreign residents have stepped up their purchases of U.S. corporates bonds after taking a break in 2018.
- Corporate spreads narrowed and quality spreads compressed on a dovish Fed and strong equity markets.
- Corporate credit curves flattened with outperformance in 7- to 10-year maturities relative to 3- to 5-year bonds.
Risk On, Risk Off, Risk On...
Spreads movements in the investment grade (IG) corporate bond market and risk assets more broadly had a yo-yo like feeling during the second quarter, with distinct risk-on (April and June) and risk-off (May) periods. Spread-positive news such as rising central bank dovishness, a Brexit extension, decent corporate earnings and solid U.S. economic data was, at times, offset by negatives such as new tariffs and threats, the yield curve inversion, slowing global growth and rising geopolitical risks. While near-term spread volatility may be unsettling, it can also provide opportunities for the patient investor, and potentially more attractive entry points. In terms of economic growth, U.S. real GDP grew by a solid 3.1 percent in the first quarter. However, economic growth has slowed in China, Japan, the EU and emerging markets. From a monetary perspective, central bank accommodation has risen, the Fed is now expected to cut interest rates, the PBoC has cut rates and the ECB has injected liquidity. In terms of fundamentals, the corporate earnings outlook for the next couple of quarters appears weak amid tariffs and slower global economic growth. However, with investors voicing concerns about high financial leverage, IG companies are responding with more debt reduction, which is credit positive.
Fundamentals: Deleveraging Slowed by Weaker Earnings
Earnings Outlook is Far from Sanguine
Corporate earnings growth has slowed as the one-time benefit from the U.S. corporate tax cut begins to fade. Operating trends have also moderated as trade tensions weigh on global economic growth. While all sectors are impacted by tariffs to a degree, some are more exposed than others. For example, commodity-oriented sectors such as Basic Materials and Energy are levered to China and global growth and reported significantly weaker earnings in the first quarter. Domestic-oriented sectors like Communications, Real Estate and Utilities had solid results. However, with nearly 45 percent of S&P 500 sales from overseas, until the trade conflict between China and the U.S. is satisfactorily resolved we would expect subpar profit growth to continue. S&P 500 earnings grew by a weak 1.3 percent in 1Q19 and consensus estimates indicate we may be in for more of the same in the second quarter. However, in a bit of good news, sales growth has remained solid and if costs can be reduced then operating margins may be preserved.
More Issuers are Focused on Debt Reduction
After a few quarters of modest declines, financial leverage (e.g. gross debt to EBITDA) among IG corporate borrowers ticked up slightly in 1Q19 as debt growth outpaced slowing cash flow growth, per Morgan Stanley. This trend could stay in place for the remainder of 2019 unless earnings growth picks up. However, the percentage of Industrial corporate borrowers reducing debt has increased in recent years following U.S. tax reform, particularly in the Capital Goods, Pharmaceuticals, Healthcare and Technology sectors. Debt reduction is an oft-stated goal by management post-merger and acquisition activity (M&A), but the key for credit is willingness and ability. Capital Goods, Pharmaceuticals and Healthcare saw elevated M&A in recent years and the increase in debt reduction during 2018 was necessitated by higher-than-trend leverage and rating agency and investor expectations. After repatriating a massive amount of overseas funds, the Technology sector has paid off debt with a portion of this and through strong free cash flow generation. Despite debt reduction efforts, we would note that S&P Global potential upgrades totaled 353 in June 2019 with potential downgrades at 518 and that the ratio at 0.7:1 is in line with the 10-year average.1 The long-term decline in U.S. corporate credit quality is intact and half of the IG market is now BBB-rated.
Technicals: Solid Demand and Lower Supply
Foreign Demand for Corporate Bonds Returns
Net foreign purchases of U.S. corporate bonds recovered in the first quarter after dropping off precipitously in 2018. Foreign residents are an important source of demand for U.S. corporates, as they have become the largest holder of corporates at nearly 30 percent of the market, followed by insurers and mutual funds.2 Net corporate supply was seasonally elevated in the first quarter, per Fed data. But IG gross corporate supply of $293 billion declined by 20 percent in the second quarter on a material drop in Technology issuance and with elevated maturities, call and tenders, net corporate fixed rate supply declined by about 40 percent, per Barclays. Fund flows remained strong with IG net inflows of $29 billion in the second quarter of 2019 compared to $6 billion in 2018.
Valuations: Credit Curves Flattened in 2Q19
Spreads Tightened Up on Dovish Fed Policy
At an average spread of 115 basis points (bps), the Bloomberg Barclays IG Corporate Bond Index narrowed 5bps in the second quarter and was 38bps tighter year-to-date. IG corporate spreads have retraced to October 2018 levels and at present are seemingly supported by a more dovish Fed that is attuned to financial market conditions. In the second quarter, BBB-rated corporates outperformed A-rated bonds, with relative spread tightening of 4bps. From a sector perspective, Communications tightened the most, by 11bps, while Energy was 1bp wider on a decline in oil prices. At the end of the first quarter steeper 5s10s credit curves presented opportunities. Perhaps not surprisingly, the corporate market reacted, and credit curves flattened in the second quarter with outperformance in 7- to 10-year maturities (10bps tighter) while 3- to 5-year bonds were 1bp wider on average.
Corporate Outlook: Sector Views
Our research analysts conduct sector scans for potential investment opportunities. In the table below, we have identified three corporate sectors with fundamentals that, in our opinion, 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.
 1 S&P Global Ratings, Credit Trends, as of July 18, 2018.
 Fed Flow of Funds, First Quarter 2019, as of June 6, 2019.
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