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Corporate Podcast recorded on July 12, 2019

Q2 2019 Corporate Bond Market Outlook

Podcast Transcript

Good day. This is Laura Lake. I am the chief investment officer at Breckinridge Capital Advisors and I'm joined today by Nick Elfner, our co-head of research, and we are going to be talking about the investment-grade corporate market and taking a brief look back at the second quarter. And looking back over that period, it was actually a pretty volatile period for investment-grade corporates. If we start at the beginning of the quarter and then move to the end, the spread or the yield advantage that corporates have over Treasuries actually didn't move that much despite the volatility. The spread only compressed by about 5bps. Also, over the quarter lower quality bonds, specifically BBB corporates, those spreads narrowed by about 6bps and they did outperform A corporates. We ended the first half of the year with corporate spreads nearly 40bps tighter on the year and they're actually back to the levels we last saw on October 2018.

Yes it is interesting, because there was clearly a distinct risk-on market in April and June and then risk-off in May. Certainly there was spread positive news such as rising central-bank dovishness, a Brexit extension, DC corporate earnings, and solid U.S. economic data, and this was at times offset by negatives such as new tariffs and threats, yield curve inversion, slowing global growth, and rising geopolitical risks. So while near-term spread volatility may be unsettling it can also provide opportunities for the patient investor of potentially more attractive entry points.

Yes, and that spread volatility and geopolitical concerns really played out in the sector performance. We saw Communications, that sector, tighten the most by over 10bps while the Energy sector spreads were relatively flat given the decline in oil prices. When we think about valuations, we talked back in Q1 about the steepness of the credit curve specifically that spreads in the 5 to 10-year range for corporates were more attractive than on the front end, and unsurprisingly the market took advantage of that in the second quarter. We saw more buying in the middle, that 5 to 10 year part of the curve, and spreads tightened.

That is right. So turning to corporate earnings you know we have seen commodity oriented sectors such as Basic Materials and Energy, that are levered to China and global growth, reported significantly weaker earnings in Q1. The corporate earnings outlook for the next couple of quarters does appear weak amid tariffs and slower global economic growth. So while all sectors are impacted by tariffs to a degree, some are clearly more exposed than others. Now on the domestic side we see communications, real estate and utilities all posted solid results but something we are monitoring is that almost 45% of S&P 500 sales is from overseas and until the trade conflict between China and the U.S. is satisfactorily resolved, we would expect subpar profit growth to continue. On the other hand, there’s always the other hand, more issuers are focused on debt reduction. So the percentage of industrial corporate borrowers reducing debt has increased in recent years particularly in Capital Goods, Pharmaceuticals, Healthcare and Technology sectors, and three of them Cap Goods, Pharma, and Healthcare saw elevated M&A in recent years and the corresponding increase in debt reduction was necessitated by higher then trend leverage and rating agency and investor expectations.

So let us turn to supply and demand. After a sharp drop in 2018, so far this year we have seen higher net purchases of corporates from foreign buyers. At the same time we have also seen lower net supply. And foreign residents are a very important source of demand for U.S. corporate bonds and they have actually become the largest holder of corporates, owning almost 30% of the market, which is very large. After them, insurers and mutual funds are the next biggest holders. When we think about issuance coming to market, investment-grade gross corporate issuance this quarter dropped by 20%, on a net basis dropped by 40%, and this was especially material within the Technology sector where we saw elevated maturities, calls and tenders as well. At the same time fund flows remain strong with investment-grade net inflows of almost $30 billion in the second quarter of 2019 and that compares to really only $6 billion in 2018, so a material increase there.

Well, I think that about does it for our second quarter market review and outlook. Thank you so much for joining us today.

 

 

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