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Corporate Podcast recorded on April 19, 2016

Q1 Corporate Market Review

Podcast Transcript

Hello this is Natalie Wright, product manager at Breckinridge and welcome to our Breckinridge podcast. Today, I am joined by Nick Elfner, Director of Corporate Credit Research and a member of our Investment Committee. Nick will review investment grade corporate market performance in the first quarter of 2016 and discuss our investment outlook. So Nick, spread volatility has been elevated recently in the high-grade corporate market. Can you take us through how corporate spreads moved during the quarter?

Sure, so volatility is right. After beginning 2016 at an average OAS of 139 bps, intermediate IG spreads moved 50 bps wider by mid-February, peaking at 189 bps according to Barclay's. However, in an impressive rally, spreads fully retraced this move essentially finishing up Q1 where they began. The 100 bps trading range that we saw in Q1 is unusual. Historically moves toward or above 200 bps in this market can be short-lived, but reversions are typically over multiple quarters rather than within just one.

I see, so given the high spread volatility, how did returns end up for the quarter?

So, due primarily to a large decline in Treasury yields, the total return for the intermediate corporate market was 2.76%, its best Q1 performance since 2012. Still, compared to duration neutral Treasuries, the market generated a relatively modest 17 bps of excess return but it was really a tale of two halves during the quarter. It was risk-off in the first half with -216 bps of excess return through mid-February. However, there was a sharp reversal in the second half with the market generating 233 bps of excess return.

Right, so given this tale of two halves, can we shift now to supply? We saw record high-grade corporate bond issuance in 2015 driven in part by record mergers and acquisitions volume. Has this strong M&A trend continued in the first quarter?

Yes, to some extent. For instance, IG corporate issuance of $378 billion in Q1 was up 2% year-over-year and the consumer staples sector was an important part of this volume, due primarily to the $46 billion AB InBev bond issuance to pre-fund its merger with SAB Miller. Now, US M&A volume of $480 billion was flat in Q1 compared to the prior year. However, M&A activity was down 42% compared to Q4. We expect M&A to decline in 2016 when compared to a record M&A in 2015, which I will touch on later in the podcast.

Well, given all this supply, what about demand indicators? How did mutual fund flows hold up in the quarter?

So, taxable bond funds reported modest net inflows of $1.6 billion in Q1. Flows recovered in March and investment grade-only funds actually brought in $11 billion in Q1 as risk sentiment improved. So fund flows have been volatile over the past few years and remain a risk to the corporate market.

All right, so let's now get a little bit more into our assessment and discuss the credit landscape. There's been a lot of debate about the credit cycle. Where do we think corporate credit fundamentals stand today?

So we continue to believe we are moving through a declining credit phase, which is characterized by high debt levels, weak profit growth, rating downgrades and relatively weak credit fundamentals. However, with somewhat tighter financial conditions and antitrust and tax inversion regulatory concerns, we do think M&A may have peaked and a balance sheet focus is now evident in energy and mining sectors where dividend cuts, equity issuance and debt reduction are prevailing. So we think we may be nearing a trough in the corporate credit cycle, and that shareholder-friendly activity may have peaked, but we think still high debt leverage remains a key risk for IG bondholders.

Okay, so with this is a backdrop, I see that we changed three key drivers in the credit trends dashboard in the quarter. Can you give us some detail on that?

Sure, so we upgraded event risk from a moderate to modest weakness. We expect M&A and activist-driven event risk to decelerate and become slightly less of a headwind for credit. Second, we upgraded industrials leverage from moderate to modest weakness. Gross leverage is at its highest point in the past 15 years. We do not think leverage will go much higher from where it is. And lastly, we upgraded capital sources from a moderate to a modest weakness. High debt is partly offset by solid liquidity and cuts to shareholder enhancements in some sectors.

Okay, so can you highlight a few strengths that we think are supportive of corporate credit right now?

Sure, from a bondholder perspective, US banks are still in good shape. US bank capital relative to nonperforming loans is at its highest point in the past 20 years, according to the FDIC. While energy exposure, low interest rates and market volatility are expected to weigh on bank earnings, litigation expenses declined and capital liquidity remains strong. Secondly, we see stable credit trends in domestic focus sectors. Consumer-oriented companies are doing fine and this group delivered solid Q4 earnings while growth in the S&P 500 profits was negative year-over-year. And finally, the Fed and major global central banks remain extraordinarily accommodative in terms of monetary policy. This has allowed for an extended period of very low borrowing costs for IG credits.

All right, so where do we see key weaknesses? What could negatively impact corporate credit?

Well, as I mentioned, gross leverage for the IG cohort is quite high, elevated debt leverage typically makes it more challenging and costly for companies to borrow and invest, leverage for the market touched 2.8 times at Q4 '15 comparable to prior cycle peaks in Q4 '09 and Q2 '02. Second, growth in capital expenditures has recently flat-lined while share buybacks and common dividends have been running at record levels. Excessive shareholder enhancements increase bondholder risk since they do not generate sales or cash flow growth to service debt obligations. Lastly, internal capital generation remains weak with S&P 500 year-over-year earnings growth of -5.1% in Q4 and for Q1, EPS may decline by 8.7% year-over-year which would be four quarters in a row per FactSet.

Right, so in light of our view on the credit cycle, what sectors are we cautious on?

Well, over the next 12 to 18 months our research analysts are more cautious on the trajectory of sector credit and ESG fundamentals in the IG, insurance, basic industry and REIT sectors. In insurance, our analyst has a negative outlook, primarily based on the sustained low interest rates that are negatively impacting investment income and activist pressure to split off key segments. In basics, our analyst has a negative outlook on the mining sector based primarily on the slowdown in China and low base metals prices and lastly, in REITs, our analyst there is more cautious on this sector due to increased supply in some apartment and office markets and our concerns that after a strong run-up in prices, that commercial real estate could soften both prices and rents which would negatively impact asset values and rental income.

Got it. So what, if any, corporate sectors, are our research team more constructive on?

Our analysts are more constructive on US banks, consumer non-cyclicals, and consumer cyclical sectors where they see stable or improving credit trends. In US banks, our analyst has a stable outlook on the sector based on steady credit and ESG trends which I discussed earlier. In consumer non-cyclicals, our analyst shifted sector outlooks to stable from negative in Q1 in the Pharma, healthcare and food and beverage sectors, an indication that we expect stable fundamentals over the next 12 to 18 months there and lastly, in consumer cyclicals, our analyst has a stable outlook based on solid consumer spending and confidence trends, favorable earnings results, and the solid US housing and auto sales cycle.

Finally, can you remind us of our overall current strategy for corporate bond investing at Breckinridge?

From a strategy perspective, the investment committee increased our corporate allocation target in government credit portfolios from 40% to 45% in February and reduced the federal government security allocation target from 30% to 25%. This was not a significant move given prior positioning but the change was opportunistic and based on the attractive relative valuation of high-grade corporate bonds that we observed in February. While spreads finished Q1 almost 50 basis points tighter than the wides achieved in mid-February, they are still about 50 basis points wider than June 2014, so we think value can still be found in the market, particularly in US banks, which notably underperformed in Q1.

Great. Well, thanks so much, Nick.

Thanks, Natalie.

We hope that you in the field have found this informative, and we look forward to joining us on our next podcast.


DISCLAIMER: The material in this transcript 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.