In Q3 2018, the investment grade corporate bond market had mixed credit fundamentals, with cyclically high leverage partially offset by improved after-tax earnings.
Key Drivers for the Quarter
- Large companies involved in debt-funded mergers and acquisitions are now primarily focused on deleveraging.
- Solid operating results at large companies are more than offset by a less-constructive earnings outlook.
- Net corporate supply declined due to lower gross issuance, overseas cash repatriation and bond redemptions.
- Foreign purchases of U.S. corporate bonds slowed, based primarily on higher U.S. dollar hedging costs.
- Spreads gapped out on risk aversion, and higher-quality corporate bonds outperformed lower-quality bonds.
Timing the Turn
Early signs of deleveraging are expected to expand during 2019. After several years of rapidly increasing corporate debt through a hyper focus on M&A and debt-funded shareholder enhancement activities, corporate financial flexibility has weakened to the point that some management teams are beginning to refocus on the balance sheet. Deleveraging is becoming a more popular management buzz word on earnings calls as investment grade (IG) industrial companies, particularly those saddled with high merger-related debt, focus more on debt reduction.
Not all IG companies have the willingness or ability to deleverage, so creditworthiness may continue to deteriorate as measured by the upgrade/downgrade ratio, the fallen angel counts and the proportion of BBB bonds in the IG corporate market. That said, if more IG companies credibly prioritize free cash flow for debt reduction, a serious balance sheet focus should eventually drive incremental credit improvement and narrow credit spreads. Getting to that point may take some time. And, record Industrial company leverage could move higher if an economic slowdown or a recession emerges. Management teams that refocus on balancing the long-term interests of shareholders with those of bondholders should be better positioned if capital markets volatility continues in 2019.
The Economy, Central Bank Policy and Geopolitical Risk
U.S. real GDP grew 3.4 percent in 3Q18, although the growth rate is expected to slow in 4Q18 and 2019. Economic growth has moderated in China and Japan, and Germany had weak 3Q18 GDP prints. The Fed sees a gradual approach to rate increases, while remaining flexible based on incoming data. Fed projections show two rate hikes in 2019 while the market is pricing in less than one. At the same time, the Bank of England and Bank of China are normalizing policy, and the ECB is expected to wind down quantitative easing (QE).
Meanwhile, the Bank of Japan is accommodative. The Chinese central bank (PBOC) responded to slowing economic growth in China by cutting the reserve ratio requirement by 1 percent for all banks in January.
Global foreign policy volatility and tit-for-tat threats to levy more tariffs on some products and sectors, for various trading partners and allies, may strain foreign relations and impact policy.
Multinational companies with global supply chains face unique challenges operating in such an environment. High geopolitical risks are viewed as a material headwind for corporate credit.
Fundamentals: Solid Profits Offset by High Leverage
Strength: Solid Operating Trends
S&P 500 Index companies reported sales and earnings growth of 8 percent and 9 percent, respectively, in 3Q18, and the outlook for 4Q18 results is solid. Margins have remained steady over the last several years, as companies have effectively managed costs through the cycle.
However, as the benefit of tax cuts rolls off and as some economies slow, operating trends may moderate (Figure 1). Deregulation in some industries is a focus for regulators and Materials, Energy and Utility sectors may benefit from less regulation while scrutiny is high in Media and Healthcare. U.S. bank regulations are likely materially softening for regional banks, but not as much for money centers. Federal tax cuts and foreign cash repatriation enhanced companies’ financial and operational flexibility and drove a material reduction in corporate bond issuance in 2018. (So far, proceeds from repatriation have been relatively balanced among shareholder enhancements, debt reduction and capital expenditures.) Cybersecurity, data privacy, reputation and other ESG risks are increasingly relevant.
Risk: Record High Gross Leverage Is a Key Risk
It’s well documented that the average credit quality of the IG corporate bond market has been declining for decades. In the ICE Bank of America Merrill Lynch Corporate Index, 50 percent of issuers were BBB at the end of 2018, versus 38 percent in 2011. While there is no one reason for this, rising indebtedness has certainly been a factor.
Furthermore, accommodative monetary policies, tax reform and low financing costs have sustained merger activity—much of it debt-financed—at a high level for the last few years. Company efforts to maintain a strong IG rating (A minus or better) have waned during this cycle, as the low after-tax cost of debt incentivized management to borrow heavily and quality spreads were very tight.
High debt leverage has weighed on creditworthiness (Figure 2) and we expect agency credit downgrades to outnumber upgrades. For instance, at S&P, global corporate bond potential rating upgrades (e.g. issuers with positive outlooks or on CreditWatch with positive implications) numbered 339 in November, lagging 544 potential corporate bond downgrades, for a potential upgrade-downgrade ratio of 0.6:1. However, larger IG companies involved in debt-funded M&A are now primarily focused on deleveraging. And, as financial conditions have tightened and financing costs have risen, merger activity may moderate going forward.
Technicals: Net Issuance and Foreign Flows Slowed
Mutual Fund Outflows Offset by Steady Institutional Buying
Gross IG corporate bond supply was just $210 billion in the fourth quarter of 2018, down from $280 billion in 4Q17. And, more significantly, on a net basis after redemptions, fixed rate IG corporate issuance was just $4 billion in the fourth quarter, down from $56 billion a year ago, per Barclays estimates. For the full year, IG corporate fixed rate net supply was just $277 billion, versus $490 billion in FY17. This is the lowest net supply since 2007.
In terms of demand, foreign purchases of corporate bonds have slowed primarily due to higher U.S. dollar hedging costs. Purchases by mutual funds and ETFs have also slowed notably. IG bond mutual funds reported $40 billion of outflows in 4Q18, as compared to $40 billion of inflows in 4Q17. Inflows were $20 billion in FY18, as compared to $138 billon of inflows in FY17, per ICI. However, private and public pensions, as well as insurers, have been steady buyers of corporate bonds (Figure 3).
Valuations: IG Corporate Bond Spreads Widened
Quality Spreads Gapped Out on Risk Aversion
Looking back, 4Q18 was a risk-off period for IG corporate bonds. For instance, the yield spread differential between the Bloomberg Barclays IG Corporate Bond Index and duration-matched U.S. Treasuries widened by 47 basis points (bps), finishing 2018 at an average spread of 153bps. In addition, lower-quality corporates, specifically BBB-rated bonds, gapped out 60bps, underperforming higher-quality counterparts such as A-rated corporates, which were 34bps wider. As expected in a risk-off environment, higher-quality AA-rated corporate bonds outperformed the IG corporate market with spread widening of 27bps in 4Q18. At 73bps, the A-rated corporate to BBB-rated quality spread moved 26bps wider in 4Q18 and is currently at its widest since August 2016 (Figure 4).
Summary of Key Perspectives
Today’s challenging corporate credit environment offers opportunities for long-term IG investors. Recent spread widening should create attractive entry points during 2019 as valuations have improved. While price and ratings risk have ticked higher, default risk for IG corporates remains near zero.
To manage volatility, deleveraging plans from large acquirers should be heavily scrutinized, and companies and sectors should be analyzed independent of the ratings agencies to determine which ones can best ride out any uncertainties in macro trends. 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, credible leverage and/or rating goals 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.
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