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Corporate Podcast recorded on April 18, 2017

Q1 Corporate Market Recap

Podcast Transcript 

Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. In today's podcast, we will recap the first quarter for investment grade corporate bonds. Today, I am joined by Nick Elfner, director of corporate credit research here at Breckinridge, and Nick is also a member of our Investment Committee. Nick is here to review investment grade corporate market returns and discuss our current investment outlook. So Nick let us start out with our performance for investment grade corporates for the first quarter. It looks like Q1 returns were solid, is that right?

Yes, IG intermediate corporate market returns were good, particularly relative to Treasuries. Corporates generated 54 basis points of excess return with credit spreads moving 6 basis points tighter in Q1 with the move lower in rates out the curve, the corporate market’s total return was 1.16%.

What can you say about Q1 performance across the investment grade credit quality spectrum?

So when Q1 intermediate BBB corporates outperformed the IG corporate market’s excess return by 20 basis points, in contrast higher quality AA rated bonds underperformed the market by 19 basis points. In terms of spreads, BBB corporates tightened 7 basis points compared with AA and A rated bonds which tightened by 3 and 5 basis points respectively. The quality spread between AA rated and BBB corporates ended Q1 at 76 basis points, its tightest level since October 2014.

Okay, so it sounds like investors were rewarded for taking more credit risk in Q1. Building on that, what sectors outperformed and in contrast, which underperformed?

So the basic industry sector outperformed the corporate market’s excess return by 60 basis points in Q1 based primarily on the relative stability of base metals prices. Finance sectors like brokers, asset managers, and insurance outperformed by 41 basis points and 22 basis points, respectively, primarily due to a proposal to repeal the fiduciary rule, solid equity market returns and the move higher in short-term interest rates in Q1, energy modestly underperformed the market by 7 basis points based on the decline in oil prices in Q1.

Okay so switching gears now, how about supply trends in Q1? Was it another big quarter from investment grade corporate bond issuance and merger and acquisition activity?

Yes, both IG supply and U.S. mergers rose. IG corporate issuance of $417 billion in Q1 was 10% higher year-over-year, and U.S. merger volume of $632 billion in Q1 increased by 34% year-over-year. So with the yield on the IG corporate index still below 3.5%, the low cost of debt has sustained high borrowing to fund M&A activity, shareholder rewards, refinancing and other uses of cash.

Interesting. So what about the demand side of the equation? Was there strong demand to keep up with the heavy corporate supply?

Yes, we saw strong flows into both taxable bond and investment grade corporate funds. U.S. taxable bond mutual funds and ETFs reported net inflows of over $100 billion in Q1, foreign flows also remain an important source of demand for corporate bonds for 2016 foreign investors bought just over $300 billion of U.S. corporate and foreign bonds per Fed data. Finally, U.S. insurers and banks remain an important source of demand. U.S. banks and insurers hold over $5 trillion of bonds and generate demand through reinvesting coupon income and maturities.

Okay. Turning now to corporate credit fundamentals, our credit trends dashboard is a heat map of key drivers of investment grade corporate markets. So looking at our dashboard, what changes did we make in the first quarter?

So we changed three drivers in our corporate credit trends dashboard this quarter. First, we upgraded our assessment of regulatory action from neutral to modest strength. Potential regulatory relief may reduce compliance costs for U.S. banks and potential corporate tax cuts and deregulation could benefit certain industrial sectors. Second, we upgraded our assessment of credit rating trends from moderate weakness to modest weakness. U.S. IG credit downgrades were elevated in 2016 based mostly on commodities weakness, but the pace of rating downgrades has slowed per S&P. Lastly, we downgraded our assessment of geopolitical risk from modest weakness to moderate weakness. Potentially rising tensions between the U.S. and Iran, Russia, North Korea and China could periodically drive a flight to safety trade.

Okay, well that is certainly one risk as we think about investment grade corporates. What are some of the other key risks that we are watching?

So a strength throughout this credit cycle has been high corporate cash liquidity relative to total debt. However, S&P sector level data shows that most sectors now have liquidity that is below average, a key risk to bondholders. While the tech sector is still very strong, 8 out of 10 S&P 500 sectors have cash to debt levels that are below the index’s ten-year average. With less cash on hand, future merger activity in certain sectors like Telecom and real estate may need to be financed with more debt issuance. A second key credit risk we are monitoring is that gross debt leverage is historically high, and is now comparable to previous recessionary peaks. IG rated companies have steadily added debt leverage since a trough in 2010. Single A rated issuers have added about a half turn of debt leverage while BBB issuers have added slightly more. Now in the recent past, leverage has typically peaked just prior to or during recessions in 2001 and 2009, but with current leverage comparable to those recessionary periods, it is reasonable to expect that leverage could peak above that if the U.S. were to enter an unexpected economic recession.

I see. Well on the flip side, what are a couple of key credit strengths that investment grade corporate bond investors can find some comfort in?

So as we have discussed in prior podcasts, U.S. Bank capital is a key credit strength and while the corporate market seems to recognize this, the rating agencies have not, at least to date. For instance, big U.S. banks rated the AA category prior to the global financial crisis are now rated mid or lower A or high BBB and since then capital ratios have moved up sharply. High U.S. bank capital argues for credit ratings upside, it is a positive offset to high industrial leverage. A second key credit strength is a more constructive outlook for EBITDA growth. Over the last few years subpar economic growth has translated into sluggish revenue expansion for IG companies. However, growth in EBITDA in 2016 held up slightly better as many large companies have focused on cutting operating costs and despite the challenging backdrop, EBITDA margins have also remained stable and may improve if global growth picks up.

I see, so how are we thinking about potential divergence in U.S. monetary policy and fiscal policy and the potential impact on investment grade corporate credit?

Well, with the Fed currently tightening monetary policy and at least two more fed hikes now expected in 2017, loose monetary policy is no longer a real tailwind for IG corporate credit, but U.S. government regulatory and fiscal policies may be poised to supplement monetary policy as a tailwind if corporate credit-friendly policies are implemented which still remains uncertain. So we continue to see some positive catalysts in the IG corporate market, primarily related to corporate profit growth potential tax cuts cash repatriation and deregulation. However, as I have noted, financial leverage and event risk is high and the possibility of tariffs, trade disputes and geopolitical flareups are risks to the IG corporate market.

Well finally, what is our current strategy for corporate bond investing at Breckinridge?

Well considering current valuations and credit fundamentals we continue to overweight AA rated and A rated corporates and underweight BBB corporates within our government credit strategies. We remain focused on investing in the bonds of high quality companies that have conservative financial philosophies and established commitment to innovation and balanced ESG risk profiles.

All right, thanks, Nick. We hope that you in the field have found this informative, and for more information, please see our first quarter 2017 corporate bond commentary on our company website. Thank you for listening and please join us again next quarter.


DISCLAIMER: The material in this podcast is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.