Much has been written about the potential impact of a Dodd-Frank rollback on bank credit fundamentals. Nick Elfner unpacks the positives and negatives of the rollback and gives our perspective.
Good day, this is Laura Lake, chief investment officer of Breckinridge Capital Advisors and I am joined today by Nick Elfner, our co-head of research, and we are going to discuss valuations, fundamentals and technicals within the investment-grade corporate bond market. We will take a brief recap of what happened third quarter 2019 and then offer some thoughts on our outlook going forward. So if we look back over the third quarter it was actually a somewhat volatile period for investment-grade corporate bonds, but if we look at the beginning of the quarter and then at the end, the yield differential of the Bloomberg Barclays Investment Grade Corporate Index did not really change much versus duration matched Treasuries. The average spread was about 115 basis points and interestingly higher-quality corporates, for example, AA corporates, outperformed with spreads about four basis points tighter compared to As and BBBs which were generally unchanged over the quarter. That really left from year-to-date perspective the investment-grade corporate index nearly 40 basis points tighter, so relatively strong returns.
Yes, it's interesting because we saw a similar volatile pattern in spreads during the second quarter with a corporate bond market reacting to external factors like tariffs, Brexit and geopolitical events. From a sector perspective, the consumer-oriented sectors such as food and beverage, supermarkets and home construction outperformed in the third quarter. Their businesses are typically more leveraged to a domestic U.S. economy and consumer spending has remained healthy. On the other hand, basic industries, energy and transportation sectors underperformed in the third quarter with typically greater exposure to commodities and global trade activity.
The other interesting note is credit curve steepened in Q3. Looking at really the front end of the curve, that maturities within one to three years, spreads were nearly 10 basis points tighter while looking a little bit further out the curve in that 7 to 10 year range, they were more than 5 basis points wider, so a nice steepening in Q3. Thinking about overall valuations they remain tighter than long-term averages. However in portfolios, we are still seeing some bottom-up opportunities, but broadly speaking when we think about valuations one of the ways we evaluate this is looking at the spread compensation per unit of leverage or basically how much credit spread we are receiving for a unit of credit risk for individual issuers and this compensation stood at about 40 basis points at the end of the third quarter versus the long-term average of about 55 basis points, so even for adjusting for leverage, valuations remain pretty tight and I think this really flows into how we have been positioned in portfolios being lower beta and defensively positioned at the stage of the cycle.
Right, so shifting to fundamentals, after several years of mergers and acquisitions and elevated shareholder rewards, we are seeing some debt reduction by larger index borrowers. By our analysts’ count, 7 of the top 10 IG index borrowers outside of banks are deleveraging post M&A and/or shareholder rewards, so while debt leverage is still high as compared to historical averages, it has begun to moderate a bit more recently.
And I think that's a good point. It has really flown into rating agency actions which is then more balanced over the recent period. And looking back, after peaking in 2015, investment-grade corporate rating downgrades declined and were below upgrades both in 2018 and so far year-to-date. And really that slowing pace of downgrades really does reflect companies’ progress towards deleveraging especially post M&A activity and post tax reform.
Right. Now not to imply there are not credit challenges, certainly operating trends are clearly mixed with decent revenue growth offset by weak earnings growth. Corporate earnings are actually forecasted to grow a sluggish 2% in 2019 kind of within the context of about 2% U.S. GDP growth, however if earnings growth turns negative, some IG companies will have difficulty in meeting deleveraging goals that have been articulated to rating agencies and bond investors, so tariff wars, geopolitical risk, are high and that may ultimately negatively impact economic growth and by extension corporate profits.
Very true, and lastly and really turning to technicals, investment grade corporate fixed-rate supply was $288 billion, increased by 36% in the third quarter and it was really based on a surge of new issuance that we saw in September. Because, really, in September alone there was a record 130 investment-grade issuers coming to market and that heavy supply was well absorbed partially due to just elevated maturities and investors looking to reinvest. But flows have remained solid. Net inflows into funds at $37 billion predominately into long-term investment-grade bond funds, and we've also seen a healthy demand from foreign buyers.
So with that, that's really our roundup for the third-quarter corporate market update. Thank you for joining us today.
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