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Corporate Podcast recorded on April 12, 2019

Q1 2019 Corporate Bond Market Outlook

Podcast Transcript

Good day, this is Laura Lake, chief investment officer at Breckinridge Capital Advisors and I am joined today by Nick Elfner, our co-head of research and today we are going to be discussing the investment grade corporate bond market taking a brief look at this last quarter, what went on, and then some of our outlook and thoughts going forward. So, looking back over the first quarter it was clearly a risk-on period for corporate bonds and it was in complete contrast to what we saw in the fourth quarter when we had a distinct risk-off period. The yield differential between the Bloomberg Barclays Corporate Index and Treasuries tightened and compressed over the quarter by nearly 35 bps. And by the end of Q1 the average spread of corporate bonds over Treasuries was about 120 bps. And we really saw the most tightening in lower quality securities, specifically in BBBs and A corporates which were 39 and 35 bps tighter respectively.

And part of what we think drove IG corporate spread tightening during the first quarter was the shift in Federal Reserve rhetoric to a more dovish tone, acknowledging a slowdown in global economic growth that could potentially impact the U.S. as well. And in addition, China's central bank has cut rates and added stimulus and the European Central Bank has also taken a more accommodative stance and that's really driven improved sentiment in risk markets including IG corporate credit.

And that's a great point, that just global central bank policy and rhetoric has clearly shifted sentiment across markets abroad and in the U.S. Thinking about the Fed, they now expect rates to remain on hold in 2019 and they lowered their forecast for U.S. GDP growth and for how high inflation may go this year. We've seen a lot of disappointing data lately from global manufacturing and that clearly weighed on the Fed's decision. But with them on hold it seems like the business cycle has further to run, so it is an interesting place for our outlook for corporate bonds.

Really from here the credit outlook is tricky in some ways as corporate profit growth looks to slow, admittedly from a strong position. The yield curve flirts with inversion from time to time and debt levels do remain high and furthermore potential IG rating downgrades continue to outnumber potential upgrades per S&P, but admittedly management teams are focused more on deleveraging as we sit today and that is a credit positive. And as mentioned, as you mentioned, with the Fed holding the line, the current expansion is set to mark the longest in U.S. history.

Yes, and I think the focus on deleveraging is important. When we think about different sectors of the corporate market, specifically banking, that has been a real source of stability for IG corporates. Earning powers improved post-tax reform and low unemployment has been driving solid trends. What you seeing on the industrial side?

Well, we have seen some progress on deleveraging. Gross leverage did decline modestly in 2018. Essentially EBITDA growth outpaced debt growth for most of the year per Morgan Stanley, however, earnings growth is expected to slow in the first half of 2019 so we may see a delay in further deleveraging. I would also point out that the financial leverage is currently above its 20-year average in six out of 13 corporate sectors and it is quite high in the other seven sectors per Bloomberg. Across the rating buckets AAs have actually been the most conservative and have added the least amount of leverage in this cycle.

So to shift gears to the technicals and supply-demand dynamics, when we ended 2018, we had a pretty big shift in demand specifically as it relates to net foreign buying of U.S. corporate bonds. It was significantly lower than it had been in the past and this was partly offset by a decline in supply in 2018 as well. So it is interesting as we enter this year the supply spigot has been not as robust as it has been recently but there is clearly pent-up investor demand.

That is right. So you know, foreign flows did effectively collapse, for lack of a better word, in 2018. You know, they dropped to $6 billion on a net basis per Fed data from over $300 billion the prior year. So that is a big change but the insurance company and mutual fund flows remained steady last year and they clearly remain important buyers of IG corporates. You know as markets have stabilized supplies recovered in the first quarter of ’19, new issue volume we’d note was healthy with IG fixed rate supply of $294 billion. That was up 3% in the first quarter year-over-year and net supply after calls, redemptions, tenders, was $117 billion. That was up 6%. In terms of flows, we have seen a slight slowdown, but you know, IG funds still did $29 billion in Q1 versus $34 billion a year ago per ICI.

And so lastly, when we think about valuations and corporate bond spreads, the average spread for the index at about 120 bps, this is back to levels that we saw in November of last year. And after the widening that we saw at the end of the fourth quarter, the bounce-back, it seems like valuations are pretty fair. One of the areas there may be some opportunity is in the 5 to 10-year steepness of the credit market.

That is right. So we have certainly seen some opportunities further up the curve across some sectors where we see a steeper credit curve, the thing we keep in mind is the U.S. corporate sectors is highly indebted, so cautious credit picking by our research team and investment team is warranted at this stage of the cycle and in this type of environment, you know, we continue to focus on investing client funds in what we think are the most creditworthy borrowers with solid business profiles, good financial flexibility, credible leverage and/or rating goals which we think is particularly important and balanced ESG risk profiles.

Great, thanks for that summary, Nick. This really wraps up our first quarter corporate market review and outlook. Thank you so much for joining us today.




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