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Corporate Podcast recorded on October 17, 2017

Q3 Corporate Market Recap

Podcast Transcript

Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today, I am 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 review corporate market performance and discuss our current investment outlook. So, Nick, let us start out with our performance for investment grade corporates. How did the third quarter returns look?

Pretty solid. The IG intermediate corporate market generated total return of 1.1% in Q3 and corporates delivered 68 basis points of excess return with credit spreads moving 8 basis points tighter.

Okay, so what were returns across the credit quality spectrum? Did lower quality outperform?

Yes it did. BBB bonds outperformed the market's excess return by 24 basis points in Q3. BBB spreads narrowed 9 basis points compared to AA and A-rated bonds that were 7 and 8 basis points tighter, respectively. Higher quality AA bonds underperformed the market by 38 basis points. So, the quality spread between AA and BBB corporates was 69 basis points at the end of Q3, which is its tightest level since September 2014.

Well building on that, what sectors outperformed, and in contrast which ones underperformed?

So, REITs which are primarily BBB rated, outperformed the market’s excess return by 43 basis points in Q3. Basic industry also outperformed by 31 basis points on wider spreads than the market and a recovery in base metal prices, and in contrast capital goods underperformed by 24 basis points based on merger and acquisition activity and expected debt supply.

Switching gears now, corporate supply was heavy in the first half, did that continue in Q3?

So, IG corporate bond supply was $377 billion in Q3, up a relatively modest 2%, year over year, but supply is over $1 trillion year to date and that is the 6th year in a row that issuance has topped that figure. Low interest rates have sustained high borrowing and corporate debt supply for several years now.

Interesting. So what about demand? Have fund flows kept up with the deluge of supply?

Yes, heavy new supply has been met by strong domestic and foreign demand for IG corporates. IG bond mutual funds reported inflows of $110 billion for the latest 12 months with about $40 billion in Q3 alone and foreign flows have increased with corporate purchases estimated at over $400 billion for the last 12 months per Fed data.

Okay, so let us turn to credit fundamentals. Our credit trends dashboard is a heat map of key drivers of corporate credit. What changes did we make to the credit trends dashboard during the third quarter?

So, we changed two drivers in our credit dashboard. We upgraded our assessments both corporate profits and operating trends from neutral to modest strength. Operating income for S&P 500 companies increased by 10% per share in the latest quarter and 10 of 11 sectors reported positive year-over-year earnings growth.

Got it. And along those lines, what are some factors that are driving the improved outlook for profits?

So, a steady U.S. economy, a weaker dollar and a recovery in European growth are factors that improve the outlook for corporate profit growth and a potential reduction in the U.S. corporate tax rate would benefit domestic U.S. focused firms that have high effective tax rates. Improvement in after-tax earnings is clearly important as it drives internal capital generation, equity valuation in a corporation's ability to self-fund its dividend and share repurchases.

And building on that, what are some other effects that tax reform could have on investment grade credit?

Well, in addition to the obvious immediate benefit to after-tax earnings, corporate tax reform could have other interesting consequences. Scrapping or limiting the tax deductibility of interest could have implications for more indebted corporations as interest rates normalize. A higher after-tax cost of debt could potentially reduce issuance itself. If legislation is passed it could also give corporations the ability to transfer funds held overseas back to the U.S. without incurring tax liability. This outcome would likely benefit large U.S. multinationals with sizable overseas cash holdings. Repatriation could also slow debt issuance over time with less need to issue debt in the U.S. corporate bond market to fund dividends and share buybacks. And lastly, growth in U.S. capital expenditures has also been sluggish in recent years. Capital-intensive sectors such as utilities, energy, transportation, and telecom could benefit from accelerated CAPEX write-offs.

Okay, well that all sounds positive from a credit perspective. On the flip side, what is a key risk for credit we are monitoring?

Well, investment grade leverage is at a record high, which is a key risk for credit worthiness and bondholders. Gross debt to EBITDA for non-financial issuers is now above the 2001/2002 U.S. recessionary peak and the increase in debt leverage is broad-based and leaves borrowers less resilient to potential economic shocks.

I see, well turning now to environmental, social governance factors, or ESG, how are we thinking about catastrophe losses and P&C insurers in the wake of some of the natural disasters we have seen recently?

So, assessing the property and casualty insurers climate change vulnerability is part of our analysis and is one of several material ESG factors in this sector. Catastrophe losses are rising after a multiyear period of relatively low losses. Catastrophe losses from earthquakes, hurricanes and other weather events have had a significantly negative impact on financial results for insurers. Global insured losses have increased from roughly $75 billion in 1980 to about $150 billion in 2016. Insurers are using complex models to manage and mitigate these risks. Primary insurance underwriters are also the utilizing reinsurance transactions to offload their exposures.

Great. Finally, what is our current strategy for corporate bond investing at Breckinridge?

So, credit fundamentals remain mixed with gross leverage at a record high while the for-profit outlook has seemingly improved. Given valuations, we are targeting an overweight to AA and A-rated corporates and an underweight to BBB corporates within the context of an overweight corporate allocation in our government credit strategies. Within the corporate sector allocation, we are overweight in the banking, pharmaceutical and technology sectors. We are underweight in the basic industry and REIT sectors. And finally, we maintain a modest barbell strategy and are duration neutral in government credit strategies relative to the benchmarks.

Okay, well thanks, Nick.

You’re welcome.

For more information, please see our third quarter 2017 corporate bond commentary which is currently on our company website. Thank you for listening.



DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.

Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.