In February, the president signed an executive order focusing on regulating the U.S. financial system, which may begin the process of reconsidering or potentially undoing parts of the Dodd-Frank Act.
Following an impressive performance in 2017, investment grade (IG) corporate bond spreads have decreased to near pre-crisis lows. As we enter 2018, we outline several economic and corporate trends that could impact future performance and help determine if spread tightening has legs.
1. Monetary Policy and the Pace of Fed Rate Hikes
The pace of Fed policy tightening in 2018 is uncertain and we consider monetary policy a key driver 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 would be appropriate in 2018. Over the past month, the Treasury curve has flattened with longer yields falling and short and intermediate yields rising, and more 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.
2. An Equity Market Correction
With many stock indices at record highs, it’s logical to expect corrections at some point. The last 10-percent correction in the S&P 500 Index was in late 2015 through early 2016. During that period, IG corporate spreads1 widened, rising over 50 basis points (bps) to an average of +215bps before ultimately retracing the move by the end of April 2016. Importantly, the correlation between IG corporate spreads and equity prices has been unusually high over the past three years at -0.86 as compared to -0.36 since 1997 (Figure 1). Quantitative easing may have contributed to rising correlations in the current business cycle, as most risk assets have responded to extraordinary central bank accommodation. Historically, correlations between corporate spreads and equities tend to rise during economic recessions (e.g. -0.73 and -0.89 during the 2001-2002 and 2007-2009 recessions, respectively). If equities materially correct in 2018, IG corporate spreads should be expected to widen, all else equal.
3. Reversals of Mutual Fund and/or Foreign Flows into Corporate Bonds
Strong demand from domestic and foreign investors has created a positive technical tailwind for IG corporate performance. Solid fund flows have continued, with IG bond mutual funds reporting LTM inflows of $123 billion.2 Foreign flows have also increased, with IG corporate purchases estimated at over $300 billion annually since 2015. At a certain point, foreign flows could reverse based on shrinking interest rate differentials, rising hedging costs, increasing currency volatility and potential credit downgrades. As an offset, the insurance sector has steady demand for IG credit driven by insurance companies’ capital, liquidity and operating requirements. Pension funds also invest in IG corporates, and may increase allocations were yields to move higher along with expected future returns.
4. Uncertain Implications of Tax Reform for Issuers
We think corporate tax reform is more likely to occur than not, although what ultimately passes into law may materially differ from what is currently proposed. As currently written, tax reform looks positive for IG corporations overall, given the potential lower corporate tax rate and repatriation parameters that may free up cash held overseas. Looking ahead, a key question for bond investors is how overseas funds would be deployed post-repatriation. We expect management teams to take a balanced approach with funds used for general corporate purposes. We would also expect merger activity to remain elevated, with some prospects for special dividend payments and debt reduction. A reduction in the U.S. corporate income tax rate would be a boon for after-tax earnings, particularly for U.S. domestic-focused corporations that generally have higher effective tax rates than U.S. multinationals. For more thoughts on the potential impact of tax reform, see our Q317 Corporate Bond Commentary.
5. Record-High Leverage in Industrials
Gross financial leverage, or total debt-to-EBITDA, for non-financial IG corporate bond issuers is at a record high – above previous U.S. recessionary highs (e.g. 1991-1992, 2001-2002, 2007-2009). With gross leverage peaking now during an expansion, it is reasonable to expect the figure could spike higher if the U.S. were to fall into recession. While we are not currently forecasting a recession, from a sector perspective we think this late-cycle increase in leverage is broad-based and leaves borrowers less resilient to economic shocks. Not surprisingly, in the 1991-1992 and 2001-2002 recessions, IG corporate spreads widened 60bps and 100bps, respectively as cash flows and credit metrics weakened. The last period of notable IG spread widening was in early 2016, when oil prices bottomed at $26 a barrel,3 concerns of a U.S. recession were raised and, as mentioned, the S&P 500 Index saw a correction.
We remain high quality and continue to monitor valuations, particularly given tight credit spreads and our more cautious view on the credit cycle. We are committed to in-depth credit research—including the integration of environmental, social and governance analysis—to thoroughly assess corporate credit profiles, mitigate risks and identify opportunities.
 Bloomberg Barclays U.S. Corporate Investment Grade Index, option-adjusted spreads.
 Investment Company Institute, as of November 29, 2017.
 WTI oil, Bloomberg data.
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.