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Corporate Commentary published on October 12, 2018

Corporate Bond Market Outlook Q3 2018

Key Drivers for the Quarter

  • Credit fundamentals are mixed, with cyclically high leverage partially offset by improved after-tax earnings.
  • Solid top-line growth reflects improved demand while cost discipline has driven strong growth in cash flow.
  • However, elevated share buybacks and M&A activity continue, which is driving a decline in cash-to-debt.
  • Corporate supply declined notably in 3Q18. Reduced TLAC supply and a drop in Tech issuance were factors.
  • Cybersecurity, data privacy, reputation issues and other ESG risks look increasingly prevalent in the IG corporate landscape.

Investment Outlook

Investment-grade (IG) corporate credit fundamentals were supported by a solid U.S. macroeconomic backdrop, recent U.S. federal tax reform and strong earnings growth, which have improved aggregate financial flexibility. Bond issuance needs have declined, creating a more positive technical as net issuance materially dropped in the third quarter. However, near record corporate gross debt leverage continues to present a key risk to creditworthiness. Thriving mergers and acquisitions (M&A) activity are one reason for elevated debt leverage, as the still low cost of debt financing has enabled jumbo corporate bond financings. In addition, share buybacks, rather than incremental debt reduction, are an ongoing major use of domestic and repatriated corporate cash. High debt levels can be comfortably serviced if the economy and cash flows continue to expand at a solid clip. However, in the event of an economic slowdown and/or recession, corporate debt levels would become less sustainable as growth in cash flow would be expected to drop. Management teams have increased financial leverage over the past several years and credit ratings have migrated steadily south. Fortunately, excessive leverage is not yet apparent in the U.S. Banking sector although an over-leveraged corporate sector could negatively impact banks through syndicated loan markets.

Fundamentals: EBITDA Recovers, but Liquidity Is Down

Strength: Healthy Economy and Regulatory Backdrop

U.S. real GDP grew by 4.2 percent in 2Q18, consumer confidence is high and wage growth is picking up. We expect four Fed interest rate hikes in 2018, as the U.S. economy is growing strongly while nearing full employment, even as the Fed normalizes monetary policy.

Deregulation in certain U.S. industries is a focus for federal regulators. Materials and Energy may benefit near-term from less regulation, while scrutiny remains high for Media and Healthcare companies. Regulations are softening for U.S. regional banks, but not as much for money center banks.

Economic growth has improved in parts of Asia while European growth has slowed slightly. Outside the U.S., the Bank of England and the Bank of Canada are normalizing policy while the ECB and the Bank of Japan remain accommodative. A strong U.S. dollar, high foreign currency debts, and China/U.S. tariffs and sanctions are headwinds for emerging markets (EM) and have negatively impacted EM financial assets.

Strength: Solid Operating Trends Reflect Improving Demand

S&P 500 Index companies reported strong growth in sales and operating earnings of 9 percent and 25 percent, respectively in 2Q18. Top-line growth reflects improved demand while cost discipline has driven solid growth in cash flow. Gross leverage declined from a recent peak as growth in EBITDA overtook debt for the first time since 2012. U.S. bank capital ratios continued to look strong but are declining from their highs with rising shareholder rewards and regulatory relief. Industrial leverage is high due to companies’ aggressive credit stance and could shatter records should an unexpected recession emerge.

Tariffs are a risk to sales and profit growth for a host of U.S. industries. This risk could grow over time if tariffs and trade tensions continue to escalate.

Risk: Shareholder Enhancements, M&A and Negative Rating Trends

While tax cuts and the repatriation of foreign cash enhance management and financial flexibility, they may also boost event risk including M&A and shareholder enhancements. Elevated share buybacks and M&A continue, which is driving a decline in cash-to-debt. For example, global M&A value increased by 19 percent year-over-year in 3Q18. The low cost of debt, higher leverage and M&A have contributed to BBB corporates becoming a larger portion of the IG corporate market currently (49 percent), versus the historical range (20-40 percent).1 At present, the median BBB-rated issuer is leveraged (e.g. total debt-to-EBITDA) at 2.8x compared to the median A-rated issuer at 2.4x, per Bloomberg Intelligence. While that gap has closed recently, the median A-rated corporate has an EBITDA margin of 21.7 percent versus 19.5 percent of the median BBB, allowing for additional financial flexibility.

In terms of the credit outlook, At S&P Global Ratings, potential corporate downgrades (e.g. issuers with negative outlooks or ratings on CreditWatch with negative implications) numbered 526 in August 2018, exceeding 363 potential upgrades for a “downgrade/upgrade” ratio of 1.4:1.

Risk: Geopolitical Risk and ESG Issues

U.S. tensions with North Korea, Iran, Russia and/or China may periodically drive a flight-to-quality trade. U.S. foreign policy volatility, and plans to impose some product/sector tariffs on trading partners and allies, may strain foreign relations. Increasing economic turmoil and social upheaval in some emerging markets has the potential to negatively impact credit risk assets. Cybersecurity, data privacy, reputation and other environmental, social and governance (ESG) risks look increasingly pertinent as rating agencies, regulators, investors and the public at large seem less patient with scandal.

Technicals: Issuance Slows while Fund Flows Rise

Demand from Foreign Buyers Has Slowed

Gross and net corporate bond issuance has declined over the last two quarters. Foreign cash repatriation, reduced Bank TLAC2 and Technology bond issuance, and high redemptions were factors in the lower net supply and supported a positive technical backdrop. Net purchases of corporate bonds by foreigners has slowed recently and rising Libor and higher hedging costs could sustain weakened demand. However, pension fund, mutual fund and ETF flows have picked up notably. And, with the bulk of their invested assets in fixed income securities, the insurance sector remains a steady source of demand for IG corporate bonds.

Summary of Key Perspectives

As the Fed continues increasing short-term interest rates, monetary policy tightening has emerged as more of a headwind for corporate credit. IG companies have steadily levered up over the past several years and are more vulnerable to a rising cost of borrowing. Gross debt leverage is near a record high among IG industrials, particularly BBB-rated borrowers, and would be expected to rise further in a recessionary scenario.

Geopolitical risks, volatility in EM, and tariff battles between the U.S. and China are additional challenges that may impact investor sentiment for risk assets. U.S. federal tax reform, strong earnings growth and a healthy U.S. banking sector partially offset the challenges for corporate credit that we have outlined above. In such an environment, we continue to focus on investing client funds in what we believe to be creditworthy corporate borrowers with solid business profiles, good financial flexibility and balanced ESG risk profiles.

Credit Trends Dashboard

In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit.

 

Statistical Summary

[1] Proxy for corporate market is the Bloomberg Barclays U.S. Corporate Index. 

[2] The Financial Stability Board has required some larger U.S. banks to meet minimum holdings of “total loss-absorbing capacity” (TLAC) securities, a change that was primarily put in place as a cushion for depositors and taxpayers.

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