Key Drivers for the Quarter
- Between March and April, economies and investment markets globally endured shocks of immense proportion due to the spread of the COVID-19 pandemic. Unprecedented government monetary policy and fiscal support helped avert market collapses and stem sharp economic declines due to business lockdowns. Recessionary conditions prevailed.
- In May and June, many states reopened businesses and relaxed social restrictions, steps met with positive investor sentiment and market performance. Resurging infections and hospitalizations in late June clouded the recovery outlook.
- Corporations raised substantial liquidity through record debt offerings. Gross investment grade (IG) fixed rate supply was $1.1 trillion for the first half of 2020, up by over 100 percent year-over-year. With money markets strained, IG supply accelerated as companies raised cash and termed out short-term debt.
- From a market technical perspective, IG fund flows recovered notably in the second quarter. The unprecedented participation of the Fed in the corporate bond market also reinforced investor confidence and demand for IG corporate bonds.
- The Barclays IG Corporate Index spread compressed by a notable 122 basis points (bps) during the quarter to an average spread of 150bps. Considering the recessionary backdrop, tighter spreads would appear to indicate investor acknowledgement of the Fed’s significant involvement in the market and the ultra-low rate environment, which may keep spreads relatively rangebound.
“The road is long, with many a winding turn.”
The economic outlook in the U.S. is at this point being defined by monetary policymakers not in terms of quarters but in years. Fed Chairman Jerome Powell announced in June that the Fed does not expect to lift its benchmark federal funds rate until 2023.
Our view remains that the economic outlook will be shaped largely by the ability of governments and corporations to initiate and maintain more-normal levels of social and economic activity. Their efforts will be shaped to a large extent by the ability of the medical community to arrest spread of COVID-19 and develop effective therapeutics to treat those who are infected. (See our 2Q20 Corporate Trends Dashboard at the end of this update).
The level of demand destruction caused by the coronavirus-related business lockdowns and restrained social and economic activities is unlike any seen in decades. The predictably negative effect on corporate credit fundamentals is substantial.
While corporate profits and balance sheets remain at risk, the Fed’s direct intervention in the corporate bond market across much of the credit quality spectrum should support the market. The market is opened now to a variety of issuers due to the Fed's corporate purchase program. That involvement improved the market tone as the quarter closed.
IG Issuers Raise Cash, Issuance Hits Record.
Gross index-eligible IG corporate fixed-rate supply was over $800 billion for the second quarter and $1.1 trillion for the first half of 2020. Net IG supply, after redemptions, was a remarkable $825 billion over the same period, up 325 percent year-over-year, per Barclays. Both periods smashed issuance records as IG companies tapped the markets aggressively, particularly in the second quarter.
The Fed began buying fixed income exchange- traded funds that invest in corporate debt in May at a pace of about $300 million a day. In June, the central bank expanded the program. It created a portfolio based on a broad, diversified market index composed of corporate bonds issued by nonbank companies that satisfy certain criteria, including that companies were investment grade-rated as of March 22 and that securities can be no more than five years to maturity. Bank of America estimated in April that the Fed could buy up to $419 billion of individual corporate bonds under the criteria it had established. The Fed plans to adjust its level of purchases based on various measures of market functioning.
Long-term IG mutual fund flows were volatile, with outflows of $57 billion in the first quarter mostly offset by inflows of $55 billion in the second quarter, per ICI.
IG Corporate Spreads Narrowed, Paced by BBBs.
The Barclays IG Corporate Index spread compressed by 122bps from March 31 through June 30, to an average spread of 150bps. Corporate quality spreads narrowed with bonds rated AA, A, and BBB at levels of 77bps, 98bps and 159bps tighter, respectively.
Poor credit fundamentals may limit spread narrowing, but Fed buying and a reach for yield may help keep spreads rangebound.
IG Leverage Is Notably High; May Peak in 2020.
Corporate debt leverage has risen in past recessions, as EBITDA has historically dropped faster than debt obligations.
Assuming a 25 percent decline in EBITDA and a 15 percent rise in debt, leverage may move from 3.0 times earnings in fiscal year 2019 to 4.5 times earnings in fiscal year 2020. Assuming an economic recovery in 2021, leverage may decline on EBITDA growth and modest debt reduction.
Year-to-date through May 31, Standard & Poor’s (S&P) downgraded $300 billion of BBB-rated corporate debt to speculative grade.
Rating pressure is building on BBB- companies and the number of potential fallen angels - downgrades from IG to speculative grade - sits at 111 globally, according to S&P. At present, corporate issuers with negative outlooks or on negative CreditWatch is 25 percent of all S&P-rated IG issuers, which is comparable to the 2009-2010 period.
COVID-19 lockdowns have reduced operating income and may increase indebtedness across a variety of sectors. Rating agency downgrades historically spike higher in periods of economic contraction. We expect this period will be no different.
ESG in a Time of Pandemic
Through our ESG research and engagement discussions, we are evaluating management decisions regarding human capital management (HCM), stakeholder engagement and supply chain management during the crisis.
You can read more about our corporate issuer engagement and ESG research during the COVID-19 crisis by reviewing The COVID-19 Crisis and Its Impact on Social Issues for Corporations and U.S. Cities.
DEI’s Role in Corporate Bond Research
At Breckinridge, HCM and diversity, equity and inclusion (DEI) are incorporated into the investment process in varying ways based on the sector, the availability and materiality of specific metrics.
DEI factors are likely to become more relevant to credit analysis in both the near- and long-term, in our view, as the U.S.’s demographic and socioeconomic profile changes. More information about our incorporation of DEI considerations in investment research is offered in Integrating Diversity, Equity and Inclusion into the Investment Process.
Corporate Trends Dashboard
In our 2Q20 Corporate Trends Dashboard, we capture our views of key drivers of IG corporate credit. Strong monetary policy and fiscal stimulus is offset by a weak economy and high financial leverage.
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