Key Drivers for the Quarter
- Central bank dovishness and corporate deleveraging were offset by tariff uncertainty and geopolitical risk.
- Debt leverage, while still notably high, has moderated as issuers are responding to agency and investor concerns.
- S&P corporate rating actions have been more balanced recently and upgrades have exceeded downgrades.
- Increased corporate supply with a surge in September issuance was offset by solid inflows and foreign demand.
- Corporate credit curves steepened in the third quarter and valuations remain tighter than long-term averages.
Doves, Liquidity and Credit
Central bank dovishness has increased, and the Fed has reduced its target for the fed funds rate twice in 2019 and is currently providing daily and term liquidity in short-term money markets. Cutting rates and providing liquidity is a positive for the investment-grade (IG) corporate bond market although the need for the Fed to do so is a concern. Volatility in repurchase (repo) markets may have potential impacts on other parts of the bond market. Corporate bond investors can spend significant time debating the elusive credit cycle and when or if issuers will become balance-sheet focused or bondholder-friendly. Over the long-term, average U.S. issuer corporate credit quality has declined in aggregate, due to many variables. For instance, the BBB-rated corporate bond market is now as large as the AAA, AA and A-rated corporate markets combined as compared to its status as 25 percent of the market in the mid-1990’s. Fortunately, the decline in credit quality has been mitigated by falling interest rates and the additional yield spread offered over government bonds. So, IG corporate bond returns have averaged about 6 percent each year since 1995, per Merrill Lynch. IG corporate bonds have a low default rate and risks are mainly ratings transition, spread volatility and interest rates, which can impact returns. Financial leverage, or the amount of debt relative to cash flow can also influence ratings, valuations and credit risk. An issuer’s material environmental, social and governance (ESG) factors are additional drivers that should be considered to assess creditworthiness and valuation.
Deleveraging (Too) Late in the Cycle?
In terms of fundamentals, after several years of mergers and acquisitions (M&A) and elevated shareholder rewards, we are starting to see more debt reduction by larger index borrowers. By our count, seven of the top 10 IG Index borrowers (ex-Financials) are deleveraging post M&A and/or shareholder rewards.1 So, while debt leverage is still high as compared to historical averages, it has moderated recently. Recognizing that Industrials sector debt levels are notably high relative to historical average, deleveraging has been a focus, which we view as a net credit positive - not to imply there aren’t credit challenges. Operating trends are clearly mixed, with decent revenue growth offset by weak earnings. Corporate earnings are forecast to grow a sluggish 2 percent in 2019 in the context of 2 percent GDP growth. If earnings growth turns negative some IG companies will have difficulty in meeting deleveraging goals that have been articulated to the rating agencies and bond investors. Tariff wars and geopolitical risk are also elevated and may negatively impact economic growth and by extension corporate profits.
Rating Actions Have Been More Balanced Recently
In the context of elevated non-Financials’ sector corporate debt leverage, it is notable to see that rating agency actions have been more balanced recently. In fact, after peaking in 2015, IG corporate rating downgrades have declined and were below upgrades in 2018 and through the third quarter of 2019, per S&P Global Ratings. The slowing pace of IG downgrades partially reflects progress in deleveraging post-M&A and tax-reform.
Increased Corporate Supply Met by Solid Demand
IG corporate fixed rate supply of $288 billion increased by 36 percent in the third quarter on a surge in September issuance. Net IG corporate fixed rate supply, after redemptions, was $129 billion. In September alone, a record 130 IG issuers tapped the market. Heavy supply was well-absorbed, partially due to elevated maturities during the quarter. Flows remained solid with net inflows of $37 billion into long-term IG bond mutual funds. Healthy foreign demand should support valuations.
Spreads Were Unchanged in the Quarter
The third quarter was a somewhat volatile period, however by the close of it, the yield differential between the Bloomberg Barclays IG Corporate Index and duration-matched U.S. Treasuries was unchanged at an average credit spread of 115 basis points (bps). Higher-rated AA bonds outperformed with spreads 4 bps tighter as compared to A-rated and BBB-rated bonds which were 1 bps wider. Credit curves steepened in the third quarter. For example, 1 to 3-year maturity corporates were 9 bps tighter while 7 to 10-year maturity corporates were 6 bps wider. From a sector perspective, consumer-oriented sectors such as Food & Beverage, Supermarkets and Home Construction outperformed given their businesses are more leveraged to a healthy U.S. consumer. Basic Industries, Energy and Transportation sectors underperformed with greater exposure to commodities and global trade activity. One way to think about valuations is the spread compensation offered per unit of debt leverage or the amount of credit spread an investor is receiving per a unit of risk. Spread compensation was 40 bps in the third quarter, which is below its long-term average of 55 bps. Valuations remain below long-term averages and with corporate spreads also relatively tight on a risk-adjusted basis we are lower-beta/defensive in our corporate positioning.
Credit Trends Dashboard
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit.
 Top 10 IG Issuers (ex-Financials): AT&T, Comcast, Apple, AB InBev, Verizon, Microsoft, CVS, Oracle, GM, Walmart.
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