Corporate Bond Commentary
Bright Green: 39%C, 0%M, 100% Y, 21%K Dark Gray: 63%K
MARCH 2015
CORPORATE BOND COMMENTARY Investment Outlook Volatility Creates Opportunity The U.S. investment-grade (IG) corporate bond market continues to benefit from a sound U.S. banking sector, healthy cash liquidity among Industrial companies and favorable technicals including steady inflows into taxable bond funds. However, while the U.S. economy has improved on the labor front, recent indicators from manufacturing and durable goods orders have been weaker and inflation readings remain benign. Economic weakness abroad, the surge in the value of the U.S. dollar and the drop in oil prices have combined to negatively impact corporate earnings. Per FactSet, firstand second-quarter earnings for the S&P 500 Index are projected to decline by 3.4 percent and 1.1 percent, respectively. Multinationals, many of which are IG corporate bond issuers, are especially affected. As we wrote in our December commentary, we anticipate a more volatile corporate market in 2015, which we think should create opportunities to buy higher quality corporate bonds at more attractive valuations. From a credit-cycle perspective, we appear to be moving into a modest declining phase characterized by rising debt and shareholder enhancements—in Industrials primarily—and slowing corporate profits. Solid bank capital and corporate liquidity are offsets. Accordingly, we are more defensive and guarded on the trajectory of corporate creditworthiness. From a sector-level perspective, we are somewhat cautious on the credit trajectory of certain companies in the IG Energy, Pharma, Food and Beverage, and Telecom sectors. We are more constructive on the U.S. Banking, Utility and Consumer Cyclical sectors.
Market Review Lower Quality Bounces Back Per Barclays, the total return for the intermediate IG corporate bond market was 1.89 percent in the first quarter. The market generated 41 basis points (bps) of excess return compared to duration-matched Treasurys. From a quality perspective, BBB-rated corporate bonds delivered an excess return of 52 bps, modestly outperforming the market by 11 bps and bouncing back from a weak second half of 2014.
Lower Quality BBB Corporates Outperformed in 1Q15 After Lagging in 2H14 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% BBB Corp.
Market
A Corp.
AA Corp.
AAA Corp.
Total Return Excess Return Source: Barclays - Intermediate Corporate Index
Decent Excess Returns Across the Board Overall, there was limited sector-level variation in excess returns during the first quarter. Energy outperformed as oil prices stabilized, providing a relief rally for the beleaguered, primarily BBB-rated sector. The four top-performing Barclays Level 3 sectors for the quarter were Energy, Communications, Brokers & Asset Managers, and Insurance, which all have a higher weighting of BBB-rated issuers than the index. Limited Variation in Excess Returns Although Energy Outperformed in 1Q15 2.5% 2.0% 1.5% 1.0% 0.5% 0%
s s grs ce on cal ket s y y y y S g al al al r li lic str od log nie nci Utilit nkin REIT stri ti erg ion an u En nicat set Mnsur orta r Cyc e Ma ncyc Indu al Go hno mpa Fina Ba Ind I nsp o sic pit Tec Co er e rat u r As N / e m m a a s h B C ce Oth m er Tra onsu orpo mer Ot an Co Brok C nsu C Fin Co
Total Return Excess Return Source: Barclays - Intermediate Corporate Index
Spreads Tightened in a More Volatile Market Corporate bond spreads are off their widest levels of the last 12 months and found some support in the first quarter. Intermediate IG spreads ended the quarter 3 bps tighter but performance was mixed over the period. For instance, the index was 4 bps wider in January, 13 bps tighter
Breckinridge Capital Advisors | Corporate Bond Commentary | p 1
CORPORATE BOND COMMENTARY, MARCH 2015
in February, and 6 bps wider in March. Volatility in the corporate market was primarily due to interest rate uncertainty, mixed economic data and oil-price fluctuations. West Texas Intermediate crude prices bounced between $45 and $55 during the quarter. Demand for IG corporates remains strong due to healthy fund flows and a favorable yield differential versus Europe.
Intermediate IG Corporate Bond Spreads Found Some Support in 1Q 115 110 105 100 Bps
95 90
80
Mar 15
Feb 15
Jan 15
Dec 14
Nov 14
Oct 14
Sep 14
Aug 14
Jul 14
Jun 14
May 14
Apr 14
75
U.S. intermediate corporate supply of $311 billion in the first quarter was up 11 percent year over year, beating the previous record set in the first quarter of 2014. Pending and completed mergers in the U.S. reached $364 billion, up 25 percent year over year. Actavis Plc issued $21 billion in bonded debt to help finance its purchase of Allergan, the largest deal since Verizon’s $49 billion bond issuance in 2013.
4.5%
$400
4.0%
$350
3.5%
$300
3.0%
$250 $200 $150
($ BIllions)
IG Intermediate Corporate New Issue and M&A Volume Both Near Records
$100
1.0%
$50
0.5% 0.0%
$0 Q1-10
Q1-11
Q1-12
Q1-13
Q1-14
X X
X X
X X
Key credit drivers that changed since last quarter:
New Issuance and Mergers: Both Nearing Record Territory
1.5%
X X X X X X
X X X X X X X X
X X X X
X X X X X X
Change Change Since Since Last Last Quarter Quarter
Source: Breckinridge
Barclays Intermediate Investment Grade Corporate Bond Index - OAS Source: Barclays Live
2.0%
Economy Economy (US) (US) Financials' Financials' Leverage Leverage Fund Fund Flows Flows // Technicals Technicals Central Bank Bank Accomodation Accomodation Central Regulatory Regulatory Action Action Corporate Corporate Profits Profits Credit Credit Rating Rating Trends Trends Litigation Expense Expense Litigation Geo-Political Geo-Political Risk Risk Economy Economy (Non-US) (Non-US) Industrials' Industrials' Leverage Leverage Event Event Risk Risk Summary Summary Operating Operating Trends Trends Capital Capital Sources Sources Management Management // ESG ESG Risks Risks
85
2.5%
Weakness Strength Strength Weakness
Q1-15
US IG Intermediate Corporate Fixed Rate New Issuance (rhs) US M&A (Pending + Completed, rhs) Barclays IG Intermediate Corporate Bond Index Yield Barclays IG Intermediate Corporate Bond Index Spread Source: Barclays
Credit Trends Dashboard A Look at What’s Changed In our Credit Trends Dashboard, we capture key drivers of IG corporate credit, as well as our view of the incremental shifts in these drivers from quarter to quarter.
• Economy (U.S.): We downgraded our assessment of this driver from moderate strength to modest strength during the quarter. While there has been improvement on the labor front, recent economic indicators including manufacturing, durable goods and consumer spending have been weaker. • Fund Flows/Technicals: We upgraded our assessment of this driver from neutral to modest strength during the quarter. The yield advantage of U.S dollar-denominated (USD) corporate bonds compared to European bonds is material and steady inflows into taxable and IG corporate funds have provided a constructive technical backdrop. • Corporate Profits: We downgraded our assessment of this driver from a modest strength to modest weakness during the quarter. S&P 500 first-quarter earnings are projected to decline by 3.4 percent year over year, per FactSet on the strong U.S. dollar and sluggish global growth.
Strength: Bank Capital Steady at Multi-Year High Tangible Equity Ratios Move Higher Capital adequacy for large U.S. banks - an important credit strength - is steady at a multi-year high, as shown in the following chart. Financial leverage at large U.S. banks has declined due to higher regulatory capital requirements and is superior to pre-crisis levels. Recent Fed bank stress tests demonstrated solid capital cushions at the largest U.S. banks under adverse economic scenarios. Furthermore, the steady decline in non-current assets among FDIC-regulated banks reflects a healthier U.S. economy. Profitability indicators like return on equity remain sub-par compared to pre-crisis levels, primarily due to sustained pressure on net interest margins, flat growth in fee-based revenues and the sizable equity capital cushions required by stiffer regulations.
Breckinridge Capital Advisors | Corporate Bond Commentary | p 2
CORPORATE BOND COMMENTARY, MARCH 2015
Strong Bank Capital & Asset Quality
Relative Yields Favor U.S. Corporates
7.4%
3.5%
7.2%
3.0% 2.5%
7.0% 2.0% 6.8% 1.5% 6.6%
1.0% 0.5%
6.4% 4Q10
4Q11
4Q12
4Q13
Since the first quarter of 2010, the average yield differential between USD IG corporate bonds relative to Euro-denominated IG corporates was 75 bps. At the end of the first quarter 2015, the average yield pickup in USD corporates relative to comparable Euro corporates was 2.0 percent, based on Barclay’s corporate bond index data. For global fixed-income investors, USD corporates appear attractive on a relative basis when compared to Euro- and Yen-denominated corporate bonds of similar credit quality.
4Q14
US Corporate Relative Yield Advantage
Tangible Common Equity / Tangible Assets Noncurrent Assets / Total Assets (rhs) Source: FDIC Banking Review
5.0% 4.5%
Strength: Corporate Liquidity a Credit Positive Consistent Growth in Cash Liquidity
4.0% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5%
Liquidity a Key Strength for S&P 500 Index $450
Q1-15
Q2-14
Q3-13
Q4-12
Q1-12
Q2-11
0.0% Q3-10
Cash liquidity remains healthy for larger U.S. companies. Excess cash built up by IG issuers during and after the financial crisis is now being utilized for capital expenditures, share buybacks and dividends. However, liquidity growth is slowing as cash is deployed for mergers and acquisitions, and other shareholder enhancements.
YTW (%)
3.5%
BAML USD Corporate Bond Index BAML Euro Corporate Bond Index Source: BofA Merrill Lynch Bond Indices
25%
$400 $350
$250
15%
$200
10%
$150 $100
Growth YoY (%)
20%
$300
5%
$50 0%
$0 Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Cash & Equivalents per Share Source: Bloomberg
Dec-13
Dec-14
Growth
Strength: Supportive Technicals Steady Fund Flows IG corporate bond mutual fund flows have averaged about $1.5 billion per week year to date. Taxable bond fund assets passed the $3-trillion mark in 2012 where they remain, creating a constructive technical backdrop as funds look to reinvest bond coupon income and maturities. Steady US Bond Fund Flows & Asset Growth
Weakness: Corporate Profits Forecast to Slow U.S. Dollar a Headwind for Growth Based on the significant headwinds related to the rapid rise in the U.S. dollar and its impact on larger multinationals, we downgraded our assessment of corporate profits in our credit dashboard from a modest strength to modest weakness during first quarter. According to FactSet, first-quarter earnings for the S&P 500 Index are projected to decline by about 3.4 percent year over year and second-quarter earnings are projected to decline by 1 percent based on a strong U.S. dollar and weak global growth. This would represent the first corporate earnings decline since third quarter 2012 when earnings declined 1 percent. S&P 500 Index Profits Set to Slow 12% 10% 8% 6% 4%
($ Billions)
3500
2%
3000
0%
2500
-2% -4%
2000
-6%
1500
Q2-13
Q3-13
Q4-13
Q1-14
Q2-14
Q3-14
Q4-14
Q1E-15
Q2E-15
1000 500
S&P 500 Index Quarterly EPS Growth (YoY) Source: FactSet, S&P Dow Jones Indices
0 1Q07 - 1Q15
Cumulative IG Corp Bond Fund Net Flows Cumulative Taxable Bond Fund Net Flows IG Corp Bond Fund Total Assets Taxable Bond Funds + Bond ETF Assets Source: ICI, Lipper, BCA
Breckinridge Capital Advisors | Corporate Bond Commentary | p 3
CORPORATE BOND COMMENTARY, MARCH 2015
Weakness: Gross Leverage is elevated Debt Growth Outpacing Cash Flow Releveraging activity among Industrials has been a consistent theme that we have written about over the past couple of years. U.S. IG gross leverage, as measured by total debt to earnings before interest, taxes, depreciation and amortization (EBITDA), moved above two-times in early 2013 and is now close to peak-of-cycle leverage last seen in the 20082009 period, according to Morgan Stanley. What is different in this cycle is that despite higher gross debt levels, net debt is still reasonable due to high cash balances. EBITDA interest coverage has actually improved due to the refinancing of legacy bonds (e.g. 5-year and 10-year bond debt). For example, the Merrill Lynch U.S. Corporate Bond Index yield was 5.23 percent in 2005, 4.56 percent in 2010 and 2.94 percent in first quarter 2015, which has spurred record refinancing activity and new bond issuance.
Absolute and Relative Debt are Rising $6,000
enhancements—in Industrials primarily—and slowing profits. Solid bank capital and corporate liquidity are offsets. These factors indicate we may be in an early phase in the declining period.
Corporate Credit Cycle Moving into a Declining Phase
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Bondholders’ benefit
2.4
$5,500 $5,000
2.2
Source: Wells Fargo, BCA, Breckinridge
($ Billions)
$4,500 $4,000
2.0
$3,500 $3,000
1.8
$2,500 $2,000
1.6
$1,500 1.4 14
14
p-
bFe
Se
2
3 l-1 Ju
2
c-1 De
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1
t-1 Oc
10
-1
g-
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09
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No
7
8
-0
r-0
pt
Ap
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6
07 bFe
l-0
c-0 De
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$1,000
BofA ML US Corporate Index - face value o/s Non-Financial IG Total Debt / EBITDA (median, rhs) Source: BofA Merrill Lynch, Morgan Stanley
Summary: Modest Decline in Credit Quality A Maturing Credit Cycle The corporate credit cycle is distinct and generally follows the leveraging and deleveraging behavior of IG corporate issuers. The cycle is driven primarily by debt growth relative to cash flow, and is typically coincident with the economic cycle. We appear to be moving into a modest declining phase characterized by rising debt and shareholder
Breckinridge Strategy Overweight High-Quality Borrowers In eligible taxable strategies, our moderate overweight to the IG corporate sector relative to our primary Barclays Intermediate Government/Credit Index is largely based on solid Bank sector fundamentals, sound liquidity among Industrial companies, supportive fund flows and technicals, and reasonable valuations. While credit fundamentals remain sound, we do think the cycle is moving into a declining stage. As we have touched on in prior commentaries, bottomup security selection is crucial given our expectation that Industrial releveraging activity will continue at a steady pace. Accordingly, across our taxable strategies, we are targeting an overweight to higher quality AA- and A-rated corporate bonds and are underweight BBB-rated bonds relative to the benchmark. From a valuation perspective, if corporate spreads widen further, we believe it may present an opportunity to buy the bonds of strong corporate borrowers at more attractive levels.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification. Breckinridge Capital Advisors | Corporate Bond Commentary | p 4
MARCH 2015
CORPORATE BOND COMMENTARY Investment Outlook Volatility Creates Opportunity The U.S. investment-grade (IG) corporate bond market continues to benefit from a sound U.S. banking sector, healthy cash liquidity among Industrial companies and favorable technicals including steady inflows into taxable bond funds. However, while the U.S. economy has improved on the labor front, recent indicators from manufacturing and durable goods orders have been weaker and inflation readings remain benign. Economic weakness abroad, the surge in the value of the U.S. dollar and the drop in oil prices have combined to negatively impact corporate earnings. Per FactSet, firstand second-quarter earnings for the S&P 500 Index are projected to decline by 3.4 percent and 1.1 percent, respectively. Multinationals, many of which are IG corporate bond issuers, are especially affected. As we wrote in our December commentary, we anticipate a more volatile corporate market in 2015, which we think should create opportunities to buy higher quality corporate bonds at more attractive valuations. From a credit-cycle perspective, we appear to be moving into a modest declining phase characterized by rising debt and shareholder enhancements—in Industrials primarily—and slowing corporate profits. Solid bank capital and corporate liquidity are offsets. Accordingly, we are more defensive and guarded on the trajectory of corporate creditworthiness. From a sector-level perspective, we are somewhat cautious on the credit trajectory of certain companies in the IG Energy, Pharma, Food and Beverage, and Telecom sectors. We are more constructive on the U.S. Banking, Utility and Consumer Cyclical sectors.
Market Review Lower Quality Bounces Back Per Barclays, the total return for the intermediate IG corporate bond market was 1.89 percent in the first quarter. The market generated 41 basis points (bps) of excess return compared to duration-matched Treasurys. From a quality perspective, BBB-rated corporate bonds delivered an excess return of 52 bps, modestly outperforming the market by 11 bps and bouncing back from a weak second half of 2014.
Lower Quality BBB Corporates Outperformed in 1Q15 After Lagging in 2H14 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% BBB Corp.
Market
A Corp.
AA Corp.
AAA Corp.
Total Return Excess Return Source: Barclays - Intermediate Corporate Index
Decent Excess Returns Across the Board Overall, there was limited sector-level variation in excess returns during the first quarter. Energy outperformed as oil prices stabilized, providing a relief rally for the beleaguered, primarily BBB-rated sector. The four top-performing Barclays Level 3 sectors for the quarter were Energy, Communications, Brokers & Asset Managers, and Insurance, which all have a higher weighting of BBB-rated issuers than the index. Limited Variation in Excess Returns Although Energy Outperformed in 1Q15 2.5% 2.0% 1.5% 1.0% 0.5% 0%
s s grs ce on cal ket s y y y y S g al al al r li lic str od log nie nci Utilit nkin REIT stri ti erg ion an u En nicat set Mnsur orta r Cyc e Ma ncyc Indu al Go hno mpa Fina Ba Ind I nsp o sic pit Tec Co er e rat u r As N / e m m a a s h B C ce Oth m er Tra onsu orpo mer Ot an Co Brok C nsu C Fin Co
Total Return Excess Return Source: Barclays - Intermediate Corporate Index
Spreads Tightened in a More Volatile Market Corporate bond spreads are off their widest levels of the last 12 months and found some support in the first quarter. Intermediate IG spreads ended the quarter 3 bps tighter but performance was mixed over the period. For instance, the index was 4 bps wider in January, 13 bps tighter
Breckinridge Capital Advisors | Corporate Bond Commentary | p 1
CORPORATE BOND COMMENTARY, MARCH 2015
in February, and 6 bps wider in March. Volatility in the corporate market was primarily due to interest rate uncertainty, mixed economic data and oil-price fluctuations. West Texas Intermediate crude prices bounced between $45 and $55 during the quarter. Demand for IG corporates remains strong due to healthy fund flows and a favorable yield differential versus Europe.
Intermediate IG Corporate Bond Spreads Found Some Support in 1Q 115 110 105 100 Bps
95 90
80
Mar 15
Feb 15
Jan 15
Dec 14
Nov 14
Oct 14
Sep 14
Aug 14
Jul 14
Jun 14
May 14
Apr 14
75
U.S. intermediate corporate supply of $311 billion in the first quarter was up 11 percent year over year, beating the previous record set in the first quarter of 2014. Pending and completed mergers in the U.S. reached $364 billion, up 25 percent year over year. Actavis Plc issued $21 billion in bonded debt to help finance its purchase of Allergan, the largest deal since Verizon’s $49 billion bond issuance in 2013.
4.5%
$400
4.0%
$350
3.5%
$300
3.0%
$250 $200 $150
($ BIllions)
IG Intermediate Corporate New Issue and M&A Volume Both Near Records
$100
1.0%
$50
0.5% 0.0%
$0 Q1-10
Q1-11
Q1-12
Q1-13
Q1-14
X X
X X
X X
Key credit drivers that changed since last quarter:
New Issuance and Mergers: Both Nearing Record Territory
1.5%
X X X X X X
X X X X X X X X
X X X X
X X X X X X
Change Change Since Since Last Last Quarter Quarter
Source: Breckinridge
Barclays Intermediate Investment Grade Corporate Bond Index - OAS Source: Barclays Live
2.0%
Economy Economy (US) (US) Financials' Financials' Leverage Leverage Fund Fund Flows Flows // Technicals Technicals Central Bank Bank Accomodation Accomodation Central Regulatory Regulatory Action Action Corporate Corporate Profits Profits Credit Credit Rating Rating Trends Trends Litigation Expense Expense Litigation Geo-Political Geo-Political Risk Risk Economy Economy (Non-US) (Non-US) Industrials' Industrials' Leverage Leverage Event Event Risk Risk Summary Summary Operating Operating Trends Trends Capital Capital Sources Sources Management Management // ESG ESG Risks Risks
85
2.5%
Weakness Strength Strength Weakness
Q1-15
US IG Intermediate Corporate Fixed Rate New Issuance (rhs) US M&A (Pending + Completed, rhs) Barclays IG Intermediate Corporate Bond Index Yield Barclays IG Intermediate Corporate Bond Index Spread Source: Barclays
Credit Trends Dashboard A Look at What’s Changed In our Credit Trends Dashboard, we capture key drivers of IG corporate credit, as well as our view of the incremental shifts in these drivers from quarter to quarter.
• Economy (U.S.): We downgraded our assessment of this driver from moderate strength to modest strength during the quarter. While there has been improvement on the labor front, recent economic indicators including manufacturing, durable goods and consumer spending have been weaker. • Fund Flows/Technicals: We upgraded our assessment of this driver from neutral to modest strength during the quarter. The yield advantage of U.S dollar-denominated (USD) corporate bonds compared to European bonds is material and steady inflows into taxable and IG corporate funds have provided a constructive technical backdrop. • Corporate Profits: We downgraded our assessment of this driver from a modest strength to modest weakness during the quarter. S&P 500 first-quarter earnings are projected to decline by 3.4 percent year over year, per FactSet on the strong U.S. dollar and sluggish global growth.
Strength: Bank Capital Steady at Multi-Year High Tangible Equity Ratios Move Higher Capital adequacy for large U.S. banks - an important credit strength - is steady at a multi-year high, as shown in the following chart. Financial leverage at large U.S. banks has declined due to higher regulatory capital requirements and is superior to pre-crisis levels. Recent Fed bank stress tests demonstrated solid capital cushions at the largest U.S. banks under adverse economic scenarios. Furthermore, the steady decline in non-current assets among FDIC-regulated banks reflects a healthier U.S. economy. Profitability indicators like return on equity remain sub-par compared to pre-crisis levels, primarily due to sustained pressure on net interest margins, flat growth in fee-based revenues and the sizable equity capital cushions required by stiffer regulations.
Breckinridge Capital Advisors | Corporate Bond Commentary | p 2
CORPORATE BOND COMMENTARY, MARCH 2015
Strong Bank Capital & Asset Quality
Relative Yields Favor U.S. Corporates
7.4%
3.5%
7.2%
3.0% 2.5%
7.0% 2.0% 6.8% 1.5% 6.6%
1.0% 0.5%
6.4% 4Q10
4Q11
4Q12
4Q13
Since the first quarter of 2010, the average yield differential between USD IG corporate bonds relative to Euro-denominated IG corporates was 75 bps. At the end of the first quarter 2015, the average yield pickup in USD corporates relative to comparable Euro corporates was 2.0 percent, based on Barclay’s corporate bond index data. For global fixed-income investors, USD corporates appear attractive on a relative basis when compared to Euro- and Yen-denominated corporate bonds of similar credit quality.
4Q14
US Corporate Relative Yield Advantage
Tangible Common Equity / Tangible Assets Noncurrent Assets / Total Assets (rhs) Source: FDIC Banking Review
5.0% 4.5%
Strength: Corporate Liquidity a Credit Positive Consistent Growth in Cash Liquidity
4.0% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5%
Liquidity a Key Strength for S&P 500 Index $450
Q1-15
Q2-14
Q3-13
Q4-12
Q1-12
Q2-11
0.0% Q3-10
Cash liquidity remains healthy for larger U.S. companies. Excess cash built up by IG issuers during and after the financial crisis is now being utilized for capital expenditures, share buybacks and dividends. However, liquidity growth is slowing as cash is deployed for mergers and acquisitions, and other shareholder enhancements.
YTW (%)
3.5%
BAML USD Corporate Bond Index BAML Euro Corporate Bond Index Source: BofA Merrill Lynch Bond Indices
25%
$400 $350
$250
15%
$200
10%
$150 $100
Growth YoY (%)
20%
$300
5%
$50 0%
$0 Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Cash & Equivalents per Share Source: Bloomberg
Dec-13
Dec-14
Growth
Strength: Supportive Technicals Steady Fund Flows IG corporate bond mutual fund flows have averaged about $1.5 billion per week year to date. Taxable bond fund assets passed the $3-trillion mark in 2012 where they remain, creating a constructive technical backdrop as funds look to reinvest bond coupon income and maturities. Steady US Bond Fund Flows & Asset Growth
Weakness: Corporate Profits Forecast to Slow U.S. Dollar a Headwind for Growth Based on the significant headwinds related to the rapid rise in the U.S. dollar and its impact on larger multinationals, we downgraded our assessment of corporate profits in our credit dashboard from a modest strength to modest weakness during first quarter. According to FactSet, first-quarter earnings for the S&P 500 Index are projected to decline by about 3.4 percent year over year and second-quarter earnings are projected to decline by 1 percent based on a strong U.S. dollar and weak global growth. This would represent the first corporate earnings decline since third quarter 2012 when earnings declined 1 percent. S&P 500 Index Profits Set to Slow 12% 10% 8% 6% 4%
($ Billions)
3500
2%
3000
0%
2500
-2% -4%
2000
-6%
1500
Q2-13
Q3-13
Q4-13
Q1-14
Q2-14
Q3-14
Q4-14
Q1E-15
Q2E-15
1000 500
S&P 500 Index Quarterly EPS Growth (YoY) Source: FactSet, S&P Dow Jones Indices
0 1Q07 - 1Q15
Cumulative IG Corp Bond Fund Net Flows Cumulative Taxable Bond Fund Net Flows IG Corp Bond Fund Total Assets Taxable Bond Funds + Bond ETF Assets Source: ICI, Lipper, BCA
Breckinridge Capital Advisors | Corporate Bond Commentary | p 3
CORPORATE BOND COMMENTARY, MARCH 2015
Weakness: Gross Leverage is elevated Debt Growth Outpacing Cash Flow Releveraging activity among Industrials has been a consistent theme that we have written about over the past couple of years. U.S. IG gross leverage, as measured by total debt to earnings before interest, taxes, depreciation and amortization (EBITDA), moved above two-times in early 2013 and is now close to peak-of-cycle leverage last seen in the 20082009 period, according to Morgan Stanley. What is different in this cycle is that despite higher gross debt levels, net debt is still reasonable due to high cash balances. EBITDA interest coverage has actually improved due to the refinancing of legacy bonds (e.g. 5-year and 10-year bond debt). For example, the Merrill Lynch U.S. Corporate Bond Index yield was 5.23 percent in 2005, 4.56 percent in 2010 and 2.94 percent in first quarter 2015, which has spurred record refinancing activity and new bond issuance.
Absolute and Relative Debt are Rising $6,000
enhancements—in Industrials primarily—and slowing profits. Solid bank capital and corporate liquidity are offsets. These factors indicate we may be in an early phase in the declining period.
Corporate Credit Cycle Moving into a Declining Phase
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Bondholders’ benefit
2.4
$5,500 $5,000
2.2
Source: Wells Fargo, BCA, Breckinridge
($ Billions)
$4,500 $4,000
2.0
$3,500 $3,000
1.8
$2,500 $2,000
1.6
$1,500 1.4 14
14
p-
bFe
Se
2
3 l-1 Ju
2
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10
-1
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No
7
8
-0
r-0
pt
Ap
Se
6
07 bFe
l-0
c-0 De
Ju
5
$1,000
BofA ML US Corporate Index - face value o/s Non-Financial IG Total Debt / EBITDA (median, rhs) Source: BofA Merrill Lynch, Morgan Stanley
Summary: Modest Decline in Credit Quality A Maturing Credit Cycle The corporate credit cycle is distinct and generally follows the leveraging and deleveraging behavior of IG corporate issuers. The cycle is driven primarily by debt growth relative to cash flow, and is typically coincident with the economic cycle. We appear to be moving into a modest declining phase characterized by rising debt and shareholder
Breckinridge Strategy Overweight High-Quality Borrowers In eligible taxable strategies, our moderate overweight to the IG corporate sector relative to our primary Barclays Intermediate Government/Credit Index is largely based on solid Bank sector fundamentals, sound liquidity among Industrial companies, supportive fund flows and technicals, and reasonable valuations. While credit fundamentals remain sound, we do think the cycle is moving into a declining stage. As we have touched on in prior commentaries, bottomup security selection is crucial given our expectation that Industrial releveraging activity will continue at a steady pace. Accordingly, across our taxable strategies, we are targeting an overweight to higher quality AA- and A-rated corporate bonds and are underweight BBB-rated bonds relative to the benchmark. From a valuation perspective, if corporate spreads widen further, we believe it may present an opportunity to buy the bonds of strong corporate borrowers at more attractive levels.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification. Breckinridge Capital Advisors | Corporate Bond Commentary | p 4
