Corporate

Commentary January 12, 2018

Corporate Bond Market Outlook Q4 2017

Key Themes for the Year Ahead

  • Tax reform is a net positive for investment-grade corporations. A key question for bond investors is how repatriated funds will be deployed.
  • U.S. banks are a source of stability, with noncurrent loans at their lowest level relative to capital since 2006.
  • Monetary policy is a driver of corporate performance, and as it tightens it becomes less of a tailwind and more of a headwind for credit.
  • The industrial sector has added record debt leverage, which could further strain metrics during a slowdown.
  • Cybersecurity threats, antitrust lawsuits and other material environmental, social and governance (ESG) risks are generally growing.

Investment Outlook

It Was the Best of Times, it Was the Worst of Times

For 2018, we expect to see continued leveraging activity in the Industrials sector, partially offset by a stable U.S. Banking sector. While tax reform may help preserve a risk-on trade through the first half of 2018, we anticipate that additional Federal Reserve rate hikes may begin to weigh on risk assets in the second half. Since the close of the financial crisis in the middle of 2009, aside from hiccups during the European sovereign crisis in 2011 and the sharp drop in oil prices in early 2016, the investment grade (IG) corporate market spread has steadily compressed. At the end of 2017, this spread was just under 100 basis points (bps), achieving the same average level as June 2007 just prior to the Great Recession. We are reminded of that time and of the Fed tightening cycle that occurred from 2004 through 2006, when risk assets rallied along the way. In that period, the U.S. economy was also expanding, stock valuations looked high and corporate bond spreads were tight. U.S. bank asset quality was also strong and if tangible capital was a little low, not to worry, since credit losses were, too. Today, we see a stronger U.S. banking system with materially higher capital adequacy than we did in 2007. On the other hand, industrial companies are more leveraged today and have seemingly forgotten about the value of a strong credit rating, especially during periods of financial market turbulence.

Strength: Tax Reform Is a Net Positive for IG Issuers

How Repatriated Funds Will Be Deployed Is Uncertain

Looking ahead, a key question for IG bond investors is how overseas funds will be deployed post-repatriation. Management teams are presumed to take a balanced approach to capital allocation, although it’s possible that the bulk of these funds could be utilized for share buybacks. Mergers and acquisitions are another probable use of cash as are special dividends, capital expenditures and debt reduction. Those with large overseas cash holdings are likely to disclose the tax implications of repatriation and, potentially, their intentions for the funds through 8-K filings or during fourth-quarter earnings.

Reducing the U.S. corporate income tax rate from 35 percent to 21 percent should be a net positive for FY18 after-tax earnings, since the effective tax rate is 29 percent for the S&P 500 Index as of December 31. U.S.-based and domestic-focused sectors could benefit the most, given higher effective tax rates than U.S. multinationals. Significant nonrecurring earnings volatility could be reported for the 4Q17 based on these tax changes, including sizable, one-time, tax-related non-cash gains and losses. However, a one-time tax-related accounting adjustment is not viewed as a credit issue.

Strength: U.S. Bank Sector Is a Source of Credit Stability

High Capital Ratios and Low Problem Loans

U.S. bank noncurrent loans are at their lowest levels relative to reserves and equity capital since 2006, which is an important source of stability for the IG corporate bond market. Historically, noncurrent bank loans have tended to rise near the end of economic expansions and during recessions. This is important because loans deemed uncollectable do not accrue interest income and must be charged off versus loss reserves. Reflecting today’s low levels of noncurrent loans and Banks’ strong underlying credit fundamentals, U.S. Bank bond spreads have narrowed. Big U.S. banks remain among the largest U.S. corporate bond issuers and their strong financial health is a key credit positive. In fact, Bank of America Corp. was upgraded in November back into the A-rating category from the BBB category by both Moody’s Investors Service and S&P Global Ratings, acknowledging its fundamental credit health.

Risk: Monetary Policy is a Key Driver of Corporate Credit

As Policy Tightens, it Becomes More of a Headwind

The pace of Federal Reserve policy tightening in 2018 is uncertain, and we consider monetary policy a key driver of performance for IG corporate credit. The Fed’s “dot plot” is a visual depiction of how voting members of the Board of Governors believe the path of interest rates will develop over the coming years. In their latest set of projections, Fed officials estimate that three quarter-point rate hikes will be appropriate in 2018.

In 4Q17, the U.S. Treasury curve flattened, with longer yields falling and short and intermediate yields rising, and more rate hikes could prompt the curve to flatten further. Were the yield curve to completely flatten or invert, this could indicate a higher probability of an economic slowdown or recession. While we are not currently forecasting a recession, this type of outcome would be expected to negatively impact corporate credit fundamentals.

Risk: Industrial Sector Has Steadily Added Debt Leverage

Elevated Leverage Could Strain Creditworthiness in an Economic Slowdown

Management teams have continued to take advantage of low debt financing costs and strong investor demand for yield by issuing record levels of debt. Over the last three years, debt leverage has risen for both A-rated and BBB-rated corporate bond issuers alike. However, the A-rated cohort’s average EBITDA margin is nearly 400bps higher than the BBB group, allowing for quicker de-leveraging were that a focus.

High borrowing has helped to fund shareholder rewards (e.g. share buybacks and dividends), which have also run at record levels. Debt growth has outpaced internally generated cash flow over the last few years, weakening issuer credit metrics. While Industrial credit fundamentals have softened, particularly BBB’s, credit spreads have continued to tighten to the point that the spread compensation per turn of leverage is notably low, and the gap has narrowed between A-rated and BBB-rated corporate bonds. At present, Industrial corporate bond investors are being asked to invest funds in weaker credits at increasingly less favorable risk-adjusted valuations.

ESG Consideration: Health and Safety in Energy E&P

A Focus on Health and Safety Practices and Performance

The exploration and production of oil and gas is a hazardous activity for workers. Health and safety practices and performance are considered a material ESG issue for this sector by Breckinridge, the Sustainability Accounting Standards Board (SASB) and MSCI. Health and safety risks are analyzed by reviewing corporate goals and reported metrics. One way of measuring performance is through an analysis of the Lost Time Incident Rate (LTIR), which is the total number of incidents resulting in lost time from work per 200,000 hours worked or per 100 full-time equivalent workers.

Breckinridge Strategy

Late in Cycle, Up in Quality

We view the credit cycle as late stage and, accordingly, maintain a higher-quality bias. As monetary policy tightens it becomes less of a tailwind and more of a headwind for credit, and any material correction in equities would be expected to negatively impact corporate spreads. Industrial companies have record gross leverage, which could further strain metrics during a slowdown. Cybersecurity threats, antitrust lawsuits and other material ESG risks are generally growing. On the other hand, regulatory relief may reduce compliance costs for U.S. banks, and capital is a strength. Industrials’ leverage is high but tax reform may slow increases and the repatriation of cash should enhance management and financial flexibility.

Given generally full valuations in the corporate market, we are targeting an overweight to creditworthy AA-rated and A-rated issuers and an underweight to more leveraged BBB-rated issuers, within the context of an overweight corporate allocation in our government credit strategies. Our investment committee is closely monitoring the overweight to corporates and, if spreads continue to move tighter, the committee anticipates additional shifts to reduce exposure may be warranted. Within the corporate sector, on a market value basis, we are overweight the Banking, Pharmaceutical and Technology sectors. We are underweight the Basic Industry, Transportation and REIT sectors. We maintain a modest barbell strategy and are duration neutral in our intermediate government/credit strategies relative to their benchmarks.

Credit Trends Dashboard

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

Statistical Summary

DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.

Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.