On June 7, Banco Santander SA announced its acquisition of Banco Popular Español for €1 following a deterioration in Popular’s liquidity position and concerns about Popular’s ability to raise further capital.
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today I'm joined by Nick Elfner, co-head of research here at Breckinridge and Nick is also a member of our Investment Committee. Nick is here to discuss our current outlook for the investment grade corporate bond market. 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?
Of course. So, let’s have a little fun though and begin with a baseball analogy. Now entering its 10th year, we think the U.S. economic expansion is beginning to feel a bit like it's in extra innings. In terms of our investment outlook with the Federal Reserve continuing to raise short-term interest rates driving a flattening yield curve bias and as U.S. and China tariff battles are set to begin, we expect volatility to continue in the U.S. IG corporate bond market.
Okay, so let's talk about fundamentals. Can you highlight a few credit strengths that we see?
Yes, so strong corporate profits are a credit strength. In Q1 S&P 500 companies reported year-over-year growth in sales and operating earnings of 6% and 11% respectively. Topline growth reflected improved demand while the U.S. tax cut buoyed the bottom line. Another credit strength is the U.S. banking sector’s solid capital position. Bank sector leverage at about 11 times on an assets-to-equity basis is well below previous recessionary peaks. That said, we do expect it to rise modestly going forward due primarily to high shareholder payouts. Finally, concentration within U.S. business has increased across multiple industries. Some sectors in the corporate market have taken on duopoly or oligopoly structures, high market share offers, barriers to entry, and pricing power, and we think is a partial offset to elevated financial leverage.
Got it. And you mentioned elevated leverage. Is that a key risk to corporate credit in our view?
Yes, we believe it is. IG industrial companies continue to leverage up. Total debt to EBITA at about 2.5 times for IG issuers is above previous U.S. recessionary periods when it typically peaks. Debt leverage is high among industrial issuers due to companies’ acute shareholder focus, aggressive credit stance, and basic indifference toward the maintenance of high credit ratings. And the extended period of low interest rates has also contributed to high debt accumulation on corporate balance sheets and has arguably weighed on relative creditworthiness.
Okay, are there any other challenges to credit we are focused on? What about event risk?
So we do see rising event risk which one would expect later in the business cycle. Global M&A value increased by 20% in Q2 year-over-year. Rising idiosyncratic risk is being driven primarily by tax reform, technological disruption, and product sustainability issues and unfortunately, we are still mostly seeing share buybacks, M&A, and other shareholder friendly uses of foreign cash from repatriation, rather than any material debt reduction. And given this, potential S&P corporate bond downgrades, which are issuers with negative outlooks or ratings on credit watch with negative implications, numbered 518 in May 2018 and this exceeded 349 potential bond upgrades for a ratio of about 1.5 to 1 per S&P.
How are we thinking about geopolitical risks and tariffs in the context of corporate credit?
So first off, we think geopolitical risk including tariffs and trade tensions is a rising concern for IG corporate credit and a key future uncertainty. We will continue to closely monitor this issue. Tariffs could adversely impact sales in China and disrupt global supply chains. Tariffs may also pressure profit margins as input costs rise. We expect U.S. corporations with material import or export exposure to tariff impacted countries to address it in earnings statements and SEC filings. A full-scale trade conflict among larger economies could meaningfully disrupt long-term capital planning for multinational corporations and weaker corporate earnings could disappoint investors.
Well, switching gears now, let's talk about corporate supply and demand. How are issuance, flows, and technicals impacting the market?
So let's start with some facts. Gross IG corporate supply was 5% higher in Q2 year-over-year and M&A has been a major driver. Six months into 2018, IG bonds have already matched the full 2017 M&A related supply per J.P. Morgan. However net supply has actually declined in Q2 due to higher redemptions and tax reform which prompted a spike in new issuance in Q4 of 17. In terms of demand, IG bond mutual funds reported about $5 billion of net inflows in Q2 and $39 billion year-to-date in 2018 and that compares to $26 billion in Q2 17, and $61 billion for 2017 year-to-date, so a bit of a slow down there. Demand for corporate bonds from foreigners is slowed as well partly due to higher hedging costs, while the insurance sector buying has increased modestly, potentially on higher all-in corporate yields. And the household sector has also recently stepped up corporate bond purchases per Fed data.
So summing it all up, what is our current strategy for corporate bond investing at Breckinridge?
So while IG corporate spreads have widened year to date, we continue to see more risks as the credit cycle looks late stage, demand trends are uncertain, and a trade war and geopolitical issues are impacting volatility and risk assets. Given challenges in IG corporates, we currently maintain a higher quality bias with an overweight in corporates rated AA and A and an underweight to more leveraged BBB rated issuers. Within the corporate sector allocation on a contribution to duration basis, our intermediate government credit strategy is overweight the banking, energy, insurance, and pharma-healthcare sectors and underweight the basic industry, REIT, and transportation sectors.
All right, thanks Nick.
We hope that you in the field have found this informative and for more detailed information on our corporate bond strategy and outlook, please see our Q2 2018 Breckinridge Corporate Bond Market Outlook which is available on our website.
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