Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today we are going to go through our investment grade corporate bond market outlook and take a look at what happened in corporate bonds in the first quarter of 2018. I am joined by Nick Elfner, co-head of research, here at Breckinridge and Nick is a member of our Investment Committee. So, Nick, before we get into a discussion of corporate credit trends, can you quickly summarize our investment outlook for the investment grade corporate market?
Sure Natalie, I am going to start with a quote. President Harry Truman once demanded “give me a one-handed economist. All my economists say on the one hand on the other...” Today we think the same could be said about credit analysts. So on the one hand, economic growth is sound, corporate profits are strong, tax and regulatory policies are seemingly company-friendly and the banking system is healthy, but on the other, the Fed is raising interest rates, credit negative event risk has continued, industrial company leverage is at a record level, geopolitical risks are high, and ESG risks are increasingly prevalent. In terms of our investment outlook we think the risks are currently tilting to the other hand. This view has informed our more defensive higher-quality positioning within the IG corporate market relative to the benchmark.
Okay so can you drill down on a credit strength like for instance corporate profit growth?
Sure, recently we've seen positive earnings growth across most sectors which is an important tailwind for credit quality. For instance, S&P 500 companies reported strong growth in sales and operating earnings of 5.5% and 10.7% respectively for 2017. All eleven S&P 500 index GICS sectors reported year over year earnings growth and ten out of eleven had positive sales growth. Consensus forecasts double-digit growth for 2018 and strong earnings growth can drive improved financial flexibility if it is complemented by a balanced capital allocation strategy.
Okay, well building on that, from a credit perspective what sectors are our research team constructive on?
We have a stable outlook on U.S. banks, strong capital, improved earnings power are key strengths, credit quality has peaked but remains solid, we are monitoring consumer credit which is beginning to soften, and share buybacks and dividends are becoming more prevalent. We also have a stable outlook on the pharmaceutical and healthcare sectors based on strong balance sheets and free cash flow, in addition to favorable demographics and its essential service profile, and finally we have a stable outlook on energy. Oil prices have stabilized driven by production cuts and management teams have focused mostly on bondholder friendly balance sheet repair.
Well, earlier you mentioned high industrial company leverage as a risk. Let us discuss that a bit more.
So financial leverage is up and interest coverage is down, and this is the most basic headwind for corporate credit quality. Gross leverage has risen to about 2.5 turns for IG issuers, exceeding previous peaks in 2002 and 2009 which was during recessions. Completed M&A dropped, but proposed mergers and acquisitions were up in Q1 with announcements across multiple sectors including technology, media, insurance and retail. Cash repatriation enhances management and financial flexibility, but it also likely raises event risk, shareholder enhancements, and leverage.
Well, considering that, what sectors are we more cautious on from a credit perspective?
So, we are less constructive on property and casualty insurers due primarily to weak pricing for commercial and reinsurance and based on significant catastrophe losses from natural disasters. We also have a negative outlook on the REIT sector. REITs carry high leverage compared to other corporate sectors and supply and demand fundamentals look less favorable in our view.
Since our last podcast, possible tariffs between the U.S. and China have emerged as a potential risk to corporate credit. How are we thinking about the impact of any tariffs to various sectors?
Well, let us start with some figures. The U.S. exported about $130 billion of goods to China in 2017. That is a big number but it's also important to keep in mind that S&P 500 companies generate around $10 trillion in total annual revenues. U.S. exports to China are concentrated in industries including aerospace, agricultural, machinery, automotive, chemicals and food and beverage, among others. A potential 25% tax could be levied on certain goods within these. Tariffs would be expected to adversely impact sales into China and could disrupt some supply chains. However, the U.S., Europe, Japan, Latin America and emerging markets remain critical places to do business as well. China has become a more important source of demand and broad-based tariffs would likely be a credit negative for certain companies, and we would expect corporations with significant sales into China to address this risk in Q1 earnings statements or SEC regulatory filings.
I see, okay. Well, switching gears now, flows and technicals have come into greater focus lately. Has supply become an issue for the market to absorb with potentially less investor demand?
So, let's start with supply. With increased volatility in equities, rates and credit, IG supply did decline in Q1 and completed M&A also dropped with fewer merger related bond deals gross IG fixed rate new issue supply was 15% lower after the Tax Reform Act was passed and ensures rush deal to market in Q4 of ’17. In terms of demand which is still sizable, foreign purchases of corporates have decelerated as U.S. dollar hedging costs have risen, and repatriation of overseas cash appears to have weakened demand for front end IG corporate bonds, pushing spreads wider. That said, while inflows into IG bond funds were flat in Q1 they are still healthy when viewed over the last 12-month period. Insurance sector purchases of corporate bonds has also slowed but is a steady source of demand with the majority of the industry’s invested assets in fixed income. So overall, we view supply and demand in the IG corporate market as more or less in balance, and as a neutral as it pertains to a credit driver.
So tying it all together, what is our current strategy for corporate bond investing?
Well given the Fed's projected path, the length of the expansion, and high corporate leverage, our Investment Committee views the credit cycle as late stage and therefore maintains a higher-quality bias across the corporate allocation within our government credit and core bond strategies. With a steady move wider in corporate spreads during Q1, valuations have improved for higher-quality credits as compared to where they stood at the end of 2017. This has created opportunity particularly in the front end of corporate bond market. That said, quality spreads are still tight as compared to history and there may be better entry points into lower rated IG credit. Accordingly given current valuations we remain overweight, AA and A-rated corporates and underweight BBB-rated issuers within
All right, thanks so much, Nick. We hope that you and the field have found this informative and we look forward to you joining us on our next podcast. For more information and our thoughts on corporate bonds please see our Q1 2018 Breckinridge Corporate Bond Market Outlook which is available on our website. Thank you.
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