Much has been written about the potential impact of a Dodd-Frank rollback on bank credit fundamentals. Nick Elfner unpacks the positives and negatives of the rollback and gives our perspective.
On the heels of the Fed meeting on Wednesday, we outline five trends that are currently top of mind in the corporate market.
1. Weak Corporate Credit Fundamentals, but Early Signs of Deleveraging
- As we discussed in Risks and Opportunities in Today’s Corporate Bond Market, large M&A activity has been one of the biggest culprits for higher investment grade (IG) debt leverage in 2018. In addition, companies have continued to funnel free cash flow to shareholders via increased dividends and aggressive share buybacks. At the end of 3Q18, debt leverage was near its post-crisis peak (excluding commodities) of 2.9 times.1 Industrial leverage was high and broad-based, leaving borrowers less resilient to potential economic shocks. Interest coverage overall was solid at 10.7 times given low interest rates, but that was still near post-crisis lows.2
- During 2019, we expect the credit cycle will slowly begin to turn. Some large deals, such as the $20 billion deal from Cigna Corp. to back its acquisition of Express Scripts Holding Co., kept debt levels elevated in 3Q18. However, it appears as though those IG companies involved in debt-funded M&A are now primarily focused on deleveraging to maintain their ratings. IG company cash needs – defined by dividends, capex, share buybacks and M&A, less cash flows from operations – fell in 3Q18 to $58 billion versus the recent peak of $115 billion in 1Q18.3 Looking forward, potentially higher interest rates, along with ratings agencies’ and investors’ expectations for deleveraging, should prompt some management teams to focus more on the balance sheet, driving bondholder-friendly activity.
2. Macroeconomic Challenges
- Much of the weakness in IG pricing has been prompted by macroeconomic issues such as U.S.-China trade negotiations, growth concerns in China, Brexit uncertainties, Italy’s budgetary standoff with the European Union and the continued flattening of the U.S. Treasury curve. The Bloomberg Barclays U.S. Corporate Investment Grade Index has been volatile in recent weeks, and the option-adjusted spread has widened 28 basis points (bps) from November 7 to December 17.4 This widening is also due to idiosyncratic risks from names such as General Electric Co. and Pacific Gas and Electric Co.
- Growth remains solid in the U.S. given strong U.S. ISM Index reports for November and a better-than-expected 0.2 percent rise in November retail sales. U.S. GDP growth has been above trend in 2018. However, a potential jump in tariffs on Chinese goods, a strong dollar, a recent revision to the ECB’s 2019 growth and inflation forecasts, a cut in GDP and CPI forecasts from Japan, and a continuation of quantitative tightening in the U.S. have all contributed to concerns about softening global growth. Slowing growth could cool corporate spending plans or curb support from the consumer. The 3Q18 data show that corporate sales and earnings growth remained solid at 8 percent and 9 percent, respectively.5 And margins remain steady, as companies have effectively managed costs through the cycle.6
- But, as the benefit of tax cuts roll off and as some economies slow, these trends may moderate (Figure 1) in 2019.
3. Rising Rates and Corporate Balance Sheets
- Low interest rates and strong cash flows have allowed IG corporates to comfortably service debt even as leverage has increased significantly. Higher rates could raise interest expense and hurt profitability. On the flip side, higher rates could push some corporates to focus on deleveraging or be more cautious in M&A and business investment, which could reduce supply in 2019 and eventually improve corporate balance sheets.
- The Tax Cuts and Jobs Act (TCJA) was generally positive for corporate cash flows (see the Q4 2017 Corporate Market Outlook podcast), which helped lift M&A spending in 2018. However, the TCJA also lowered corporate tax rates, which made debt financing more expensive relative to equity financing. Higher interest rates further raise the cost of debt. All told, debt-financed M&A could slow in 2019.
- The Treasury curve has flattened year-to-date. The corporate curve has also flattened (Figure 2).7 A concern for 2019 is further flattening and inversion of the Treasury curve. In general, a flat or inverted Treasury curve could exacerbate late-cycle concerns given higher short-term funding costs. Bank net interest margins8 could be pressured as rising deposit and short-term funding costs may outpace yields on earning assets.
4. More Downgrades but Still-Low Defaults
- In the ICE Bank of America Merrill Lynch Corporate Index, 50 percent of issuers were BBB, versus 38 percent in 2011. The increase reflects post-crisis downgrades among banks, high leverage at industrials and Energy company stress after oil prices plummeted in 2015 and 2016. The focus on downgrades is warranted given the rise in leverage, the late-cycle risks in corporates and the headlines about recent fallen angels such as Xerox Corp. hitting the news.
- The IG rating category with the most issuers with a negative outlook is the BBB- sector (13 percent of total BBB- issuers are on negative outlook). This is not surprising given the high growth in BBB- debt issuance during this cycle. It could indicate that fallen angels might increase during the next recession.
- However, we are also closely monitoring risks in single A credits. Recent downgrades of General Electric Co., Lowe’s Companies and Anheuser-Busch InBev shifted more than $230 billion of debt from single A to BBB.9 Companies that have levered up are often under scrutiny from the ratings agencies, and those companies unable to withstand rate volatility or softer economic growth are particularly vulnerable to price and ratings risk.
- That said, we think that recent spread widening could create attractive opportunities during 2019 as valuations have improved. While price and ratings risk have ticked higher, default risk for IG corporates remains near zero. We are also seeing more focus on deleveraging from equity investors, as twice as many Russell 3000 companies mentioned “deleveraging” on their earnings calls in November versus in 2014, per Bloomberg.
5. Mixed Technicals
- December supply is set to be the lowest on record, per Barclays, as companies shied away from issuing into financial market volatility, wider spread levels and uncertain macroeconomic conditions. After strong issuance in 1H18, 3Q18 corporate supply declined partly due to reduced TLAC supply10 and a drop in Tech issuance. October and November issuance has been moderate, and Corporate supply declined notably in 3Q18. Overall, year-to-date supply is $1.2 trillion as of November 30, versus $1.4 trillion for the same period last year.
- However, the positive technical of low supply has been more than offset by outflows, as 2018 has seen 15 weeks of outflows, per Barclays. For the week ending December 19, high grade funds saw outflows of $5.3 billion, the third largest outflow of the year, per EPFR Global and Bank of America Merrill Lynch. The outflows stem from poor performance, macroeconomic concerns and risk-off sentiment. In addition, foreign purchases of corporate bonds have slowed, primarily due to higher U.S. dollar hedging costs.
- Renewed focus by corporate management teams to delever and improve balance sheets could lead to lower supply in 2019. In addition, corporate coffers continue to benefit from repatriated cash that lessens the need to issue debt.
- Demand challenges could continue due to rising rates that hurt returns and increase hedging costs. However, higher all-in yields11 could help mitigate some declines in demand.
 JP Morgan, as of December 7, 2018.
 JP Morgan, as of December 7, 2018.
 Bank of America Merrill Lynch, as of December 7, 2018.
 Bloomberg Barclays, as of December 17, 2018.
 Bloomberg and Breckinridge Capital Advisors, Data for the S&P 500 Index, as of December 19, 2018.
 Margin data taken from High Grade Fundamentals: 3Q18 Report, JP Morgan, as of December 7, 2018.
 JP Morgan, as of December 13, 2018.
 The net interest margin is a measure of a bank’s profit margin on its investing and lending activities. It is calculated as follows: (Net interest income / Average Earning Assets] *100.
 Barclays, per video, “IG Downgrades Big Worry for 2019, Says Barclays's Graper,” Bloomberg, December 18, 2018.
 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.
 The yield-to-worst on the ICE BofAML U.S. Corporate Index was 4.28 percent on December 19, 2018, as compared to 3.27 percent on December 19, 2017.
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