Key Drivers for the Year
- Fed accommodation increased with three rate cuts implemented in 2019 and ongoing liquidity provided through repo markets and Treasury purchases.
- After tariffs and weak economic growth in 2019, corporate earnings should expand as major economies benefit from greater central bank stimulus.
- Bond fund and foreign flows were sizable in 2019, supporting demand. If flows were to reverse course, there could be material implications for corporate market liquidity in 2020.
- Actual and threatened tariffs among major trading partners (e.g., U.S./China, U.S./Europe, etc.) negatively impacted global growth in 2019 and long-term uncertainty remains as we enter 2020.
- Full valuations limited bond spread narrowing potential and pure beta performance. However, we think bottom-up opportunities remain in post-M&A, credible deleveraging stories.
Don’t Expect a Repeat
In 2019, the U.S. investment-grade (IG) corporate bond market generated its highest total return (14.5 percent, per Barclays) since 2009. To us, 2020 looks like a year to clip coupons in the IG corporate market. With spreads now below 100 basis points (bps) and seemingly rangebound interest rates, IG corporates should be able to generate modestly positive total and excess returns in 2020. Risk assets including IG corporate bonds should continue to be supported by accommodative central bank policies in 2020. Stimulative policy and low global interest rates should sustain a global reach for yield. Corporate profit growth looks set to rebound in 2020 and earnings should expand as key economies benefit from policy stimulus and potentially fiscal stimulus. Full IG valuations will likely limit spread narrowing potential and pure beta performance, but we believe bottom-up opportunities remain in deleveraging stories. With corporate spreads approaching cycle tights, we have taken a more defensive position given late-cycle dynamics.
A risk to our investment thesis is a worsening of trade conflicts that negatively impacts growth, profits and issuers’ deleveraging targets. And, the U.S. election is a key uncertainty in the back half of 2020, which could impact IG bonds.
Corporate Leverage Is High, But So Are Margins
With market participants concerned about high corporate leverage, deleveraging looks set to continue in 2020. Debt use in mergers has declined since peaking in 2017, per Barclays, and several of the largest borrowers in the Bloomberg Barclays U.S. IG Corporate Index are actively deleveraging post-M&A and, thereby, reducing overall market-issuer weighted leverage (see Figure 1). Leverage looks set to decline slightly in 2020 as cash flows expand and key economies benefit from central bank stimulus. It’s notable, and not well-reported, that IG corporate issuer EBITDA margins bottomed in 2014 and have steadily improved on M&A-related revenue growth and costs savings. In fact, EBITDA margins at about 29-percent are their highest point in the post-crisis era per Barclays. We see stable-to-improving fundamentals in sectors like Banking, Communications and Health Care. Alternatively, we see declining fundamentals in Chemicals, Diversified Manufacturing and Energy.
Sustainability Emerging as Key Credit Driver
As it relates to environmental, social and governance (ESG) factors, we have found that IG issuers are devoting an increasing amount of attention to sustainability. The focus and effort on sustainability initiatives is showing up in a variety of ways, including spending on corporate responsibility activities, corporate sustainability reporting, hiring of chief sustainability officers, and tying sustainability goals to managerial responsibilities. Through our engagement discussions with corporate issuers, we are seeing steady improvements in ESG disclosures and issuers’ ability to articulate cohesive sustainability strategies. Large issuers are also issuing more detailed corporate sustainability reports (CSR).
Carbon transition risks may have significant implications for credit quality. These risks stem from the global economy’s shift toward low-carbon technologies to help mitigate the impacts of climate change. Carbon transition risks for corporate bond issuers can manifest in myriad ways including reduced demand for oil, gas and refined products, implementation of carbon taxes that increase corporate and consumer costs, potential fines and legal settlements from global regulatory bodies, reputational risks that challenge the ability of companies to attract and retain talent and customers. Other risks include the potential for stranded assets for oil and gas companies if demand declines as the world moves toward cleaner energy. For details, please see our ESG Newsletter piece, “Carbon Transition Risk Engagements Reveal Global Disparities”, here.
Rating Actions Have Been Balanced Post-Crisis
Over the past 10 years, S&P has upgraded 593 U.S. IG corporate ratings and downgraded 604, for a ratio of 0.98. From 2012-2014, upgrades exceeded downgrades while from 2015-2017, it flipped. Since 2018, the up/down ratio is 1:1. Rating actions should be balanced in 2020 as improved earnings are partially offset by M&A and tariff headwinds. Not to imply there aren’t credit challenges. Operating trends are mixed, and some issuers may have difficulty meeting deleveraging targets. If sustained, trade conflicts could further negatively impact economic growth.
Increase in Supply Met by Consistent Demand
Index-eligible IG corporate fixed-rate supply was $993 billion in 2019, up by 8 percent year-over-year, but below the 2015-2017 amounts. IG fixed rate net supply of $350 billion was up 26 percent in 2019, per Barclays. Consensus supply estimates for 2020 suggest a dip in both gross and net supply based on slowing M&A, deleveraging goals, more overseas IG issuance and high U.S. debt redemptions.
Demand was solid with IG fund inflows of $160 billion in 2019 and healthy foreign flows (see Figure 3). Demographics have driven steady flows into funds and that should continue. The insurance sector continued its tradition as a steady buyer of corporate bonds given insurers’ need for high-quality duration. Corporate market liquidity is still a question mark. While adequate for new issue and smaller secondary lots, liquidity is an ongoing concern that could worsen if fund flows were to reverse in a meaningful way.
Positive Carry, Limited Spread Compression
At 93bps off, the IG Corporate Index spread compressed by 60bps in 2019 and is back to February 2018 levels. Full valuations have limited spread narrowing potential and pure beta performance, but we think bottom-up opportunities remain in deleveraging stories. While spread compression opportunities are limited, IG corporates have the potential to outperform Treasuries through the extra yield and carry offered in corporates.
Valuations are below long-term averages on an absolute basis and relative to market-weighted leverage. Case-in-point: spread per unit of leverage was 29bps at the end of 2019, which is below its long-term average of 55bps. However, spreads are generally wider than competing global IG corporate bond asset classes.
U.S. Presidential Election
Expect Volatility in Second Half of 2020
Volatility in risk markets, including corporate bonds, could pick up in the second half of 2020 as participants place their bets ahead of election night. Wall Street seems to favor gridlock, so unless there is a Democratic or Republican sweep, corporate bonds should perform favorably post-election. If a progressive Democratic wins the presidency, and the Dems sweep the House and Senate, there could be material impacts to corporate bonds. An increase in the corporate tax rate and/or a boost in the minimum wage could negatively impact earnings and free cash flow. An Elizabeth Warren or Bernie Sanders presidency with control of one or both houses, would likely present a more challenging regulatory backdrop. Large Energy, Pharmaceutical and Technology companies could face increased regulation and potentially lower profits. Large Banks could face greater regulation. Economic, fiscal and tax policies could be materially different, depending on the election outcome. Climate change will march on and forward-thinking companies that can look long-term will likely be better positioned to manage climate change and other ESG risks and opportunities.
Credit Trends Dashboard
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit.
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