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Corporate Podcast recorded on October 15, 2018

Q3 2018 Corporate Market Outlook

Podcast Transcript

Good day. This is Laura Lake, CIO of Breckinridge Capital Advisors. And I'm joined by Nick Elfner, our head of corporate research. Today we are going to talk about the investment-grade corporate market taking a look back at what happened over the summer and our thoughts going forward. So looking back over the third quarter, it was a strong quarter for the investment-grade corporate bond market. Performance was strong, out-performing U.S. Treasuries as corporate spreads tightened so the yield advantage that investors receive in corporate bonds versus the yield they receive in Treasury bonds, that relationship tightened over the quarter leading to outperformance. In addition, lower quality corporates, specifically BBBs, outperformed higher-quality counterparts.

And part of what's really been driving this is the U.S. economy which has been firing on all cylinders.

Exactly. Second-quarter GDP grew at a very impressive 4.2%. We have seen strong growth in consumer sentiment and consumer spending. Payrolls have exceeded expectations through most of the summer and the unemployment rate remains relatively low, below 4%, and some of the lowest numbers we have seen in almost 40 years. So Nick, what do you see as some of the key drivers in the corporate market?

Well, Laura, as always there are positives and negatives that impact our investment outlook for the corporate bond market. In terms of challenges, as you pointed out as the Fed continues to raise interest rates, monetary policy tightening has emerged as more of a headwind for corporate credit I think we would say. Corporates has steadily also levered up at a debt to the balance sheets over the past several years and are more vulnerable to a rising cost of borrowing. Another challenge that we are seeing is technological disruption, or the Amazon effect, which really has presented some challenges to companies across several consumer-oriented industries. And, thirdly, unfortunately, we are still mostly seeing shareholder-oriented uses of foreign cash that has come back from overseas rather than any material debt reduction which would be a credit positive.

On the other hand, there is always the other hand, we do think tax reform, strong earnings growth, and a healthy U.S. banking sector partially offset some of these headwinds. But overall, we have become more defensive as an Investment Committee this year and we have modestly trimmed our corporate allocation target based on valuations and deteriorating credit fundamentals.

And, I think the supply and demand dynamic has been interesting as of late and broadly speaking, we have seen lower net corporate supply but it's been matched by lower demand. Specifically, on the supply side, both on a gross basis and on a net basis, corporate issuance has declined over the last two quarters. Foreign cash repatriation that you mentioned is one factor along with reduced issuance by banks and the tech sector as well.

We have also seen high redemption so that's driven some lowered net supply figures too.

Exactly and what have you been seeing on the demand side?

In terms of demand we note that net purchases of corporate bonds by foreigners per Fed flow funds data have slowed the last couple of quarters, partly based on higher hedging costs for foreign currency. On the other hand, pension funds, mutual funds and ETF flows have picked up so there's been a bit of an offset to some of that weaker foreign demand and the other sector that continues to buy steadily remains a steady source of demand support is the insurance sector. Overall, I think we see technicals as more of a neutral as it pertains to key drivers right now.

So the supply and demand dynamic has been a key driver but also geopolitical risks which we have had quite a number of headlines as of late. The trade war, tariffs, the impact on emerging markets and their potential to spill over to global developed markets and investment-grade sectors. In the context of corporate credit, historically we have seen things like trade tensions with North Korea, issues with Iran, Russia or China. Some of those have historically spilled over into a flight to quality in the U.S. markets. It specifically typically hit the U.S. Treasury market but how do you think this could impact U.S. credit markets?

So, unclear, but I think we do agree that prolonged tariffs or trade disputes, particularly if tariffs keep rising at a higher level, would be a headwind for corporate credit. They can reduce sales in certain markets, and increase input costs and we started to see some companies discussing that as we move through second-quarter into third quarter earnings. Trade tensions and tariffs between the U.S. and China are particularly problematic potentially for manufacturing sectors such as autos, aerospace, and diversified manufacturing. And, you know, we think if there's any continued escalation it would be a credit negative in our view but it remains to be seen how this will all play out over time.

Great. So that's it for our third quarter corporate outlook, thank you for joining us.



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