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Corporate Podcast recorded on January 10, 2019

Q4 2018 Corporate Bond Market Outlook

Podcast Transcript

Good day. This is Laura Lake, CIO of Breckinridge Capital Advisors and I'm joined by my colleague, Nick Elfner, co-head of credit research. Today, we're going to be discussing the investment grade corporate bond market, taking a brief look back at the fourth quarter of 2018, and also sharing some of our thoughts and themes for 2019, the year ahead. Starting off by looking back over the fourth quarter last year, it was clearly a risk-off period for the corporate bond market. The yield differential, or the increased yield that investors are demanding to own corporate debt over Treasury debt, that differential, that spread differential, widened by about 50 basis points over the fourth quarter and that's relative to similar duration Treasuries. The spreads ended the year at about 150 basis points over Treasuries, it's the highest level that we've seen in nearly the last two years. In addition, in this risk-off move we saw lower quality investment grade corporates, specifically BBB corporates, underperform their higher-quality counterparts.

And part of what we think drove the corporate spread widening during the quarter was rising macroeconomic challenges which would include tariffs, growth concerns in China, Brexit uncertainties, and rising worries that the U.S. economy could eventually slow as global growth seems to falter.

Exactly. And U.S. GDP growth was above trend in 2018, but as we move into 2019, there are plenty of headwinds coming into the new year. We've got a stronger dollar, we have central banks in both Europe and Japan revising downward their growth and inflation forecast, and we have continued quantitative tightening in the U.S. as the Fed's balance sheet continues to shrink. All of this has really contributed to market's concerns about softening global growth. And slowing growth could cool corporate spending plans, one of the things we've been talking about here at Breckinridge. They could also curb support from the consumer in terms of how much they're willing to spend. So putting all that in context of the corporate bond market, Nick, what are some of the top things that you're thinking about?

Well, one emerging theme that we'd highlight is deleveraging. After several years of rapidly increasing corporate debt, financial flexibility has weakened to the point that some management teams are refocusing on the balance sheet. Deleveraging is becoming a more popular buzzword on earnings calls as industrial companies, particularly those saddled with high merger-related debt, start focusing a bit more on debt reduction.

Increased debt reduction, clearly a good thing, but not all companies have the willingness or the ability to deleverage, so credit-worthiness is still continuing to deteriorate. I'm thinking over the last couple of years just large M&A activity, it's been one of the biggest culprits in terms of higher debt levels.

Absolutely it has and record industrial company leverage could move higher if an economic slowdown or recession emerges. That said, if more companies credibly prioritize free cash flow for debt reduction, a serious balance sheet focus should eventually drive incremental credit improvement and narrow credit spreads but getting to that point may take some time. Now management teams do focus on balancing the long-term interests of shareholders, and bondholders should be better positioned if volatility in capital markets continues in 2019.

So deleveraging, one theme that we've been discussing. Another theme in the corporate bond market is just the amount of BBB debt outstanding relative to historic levels and with that, the potential for fallen angels or credits that were rated investment grade and get downgraded to high-yield. One of the things that we've been looking at is the composition of the corporate index and looking back at 2011, about 38% of the corporate market was rated BBB. Today it's about 50% so the credit quality of the corporate market has been declining for decades and it really indicates less financial flexibility and creditworthiness overall.

That's right. So, the increase in BBBs since 2011 really reflects a few things: post-crisis downgrades among banks, energy company stress after oil prices plummeted in 2015 and 2016, and as we've discussed, increasing leverage in industrials. Now the IG rating category with the most issuers with a negative outlook is the BBB- sector. This is not surprising given the high growth in that rating bucket, and you know, one step away from high-yield in that case. The focus on downgrades is warranted given the high leverage and late cycle risks that we've seen, however some sectors have seen upgrades like the U.S. banks overall, but we do expect agency credit downgrades to continue to outnumber upgrades in 2019, just like last year.

So, shifting gears to supply and demand and looking back at what happened in the fourth quarter, technical seemed like a mixed bag. On the one hand, we had gross investment grade corporate supply decline by about 25% which was a positive technical. On the other hand, we saw investment grade funds reporting outflows of about $40 billion in the fourth quarter which was a negative technical. So, is supply and demand, has that really just been matched?

I think what we've seen, as you said, is supply continues to come down. For the fourth quarter actually, gross supply was $210 billion and that was down from $280 billion if you compare it year-over-year and for the full year, we had a big drop in net supply. So gross minus redemptions is net supply, that was $277 billion compared to $490 billion in 2017, the lowest net figure we've seen since 2007. So as you mentioned, the market is certainly not being overwhelmed with new issuance. In terms of demand, breaking that down a bit more, foreign purchases of corporate bonds have slowed, we've seen that from a Fed flow funds data the last few quarters, and as you mentioned, you know, for the year, funds saw $20 billion of inflows, that's down from $138 billion in 2017. So yes, corporate supply has fallen as demand for corporates has slowed from some fairly key buyers.

So, thinking about valuations or where bonds are trading, it seems that today's rather challenging corporate credit environment offers some opportunities to longer-term investors, especially given that corporates are less expensive than they were just a few months ago, so that recent spread widening or the recent yield divergence from Treasuries could create attractive entry points in 2019. We could see volatility in prices and have ratings risks, like we mentioned, but default risk for corporate still remains very low.

Yes, that's right. Credit spread compensation has improved as mentioned over the last few months, but to manage that volatility, you know, we look at companies with deleveraging plans that are credible and large acquires that have put on substantial amounts of debt, those plans need to be heavily scrutinized and all companies and sectors really should be analyzed independent of the rating agencies to determine which ones, you know, we as a firm think can best ride out any uncertainties in the forward macrotrends.

Great. So that's it for our fourth quarter corporate market recap and outlook for the beginning of 2019. Thank you for joining us.



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