Q1 2016 CORPORATE BOND COMMENTARY
COMMENTARY
Q1 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Corporate credit cycle may be
nearing a trough. M&A may have peaked and in Energy and Mining sectors, dividend cuts, equity issuance and debt reduction prevail.
• Shareholder-friendly activity
may have peaked. Rating agency downgrades, bond spread widening and shareholder concerns incentivize management teams to refocus on financial flexibility and a strong balance sheet.
• High debt leverage is still a risk for bondholders.
• For U.S. banks, robust capital levels are a key credit strength.
INVESTMENT OUTLOOK Credit Fundamentals May Be Bottoming Spring came early on the East Coast of the U.S. this year, with green shoots visible in March both on the ground and in the investment grade (IG) corporate bond market. Moderate growth in consumer spending, employment and bank lending are supportive of domestic economic activity. In prior Corporate Bond Commentaries, we have highlighted the releveraging by IG corporate borrowers and what has at times seemed like an excessive focus on near-term shareholder enhancements, which in some cases have negatively impacted balance sheets and credit quality. At the moment, earnings are weak, indebtedness is nearing a cyclical peak and the agencies are downgrading credit ratings more often. However, while global economic activity, central bank policy and management actions are wild cards, we think balance sheets may begin to improve over the next several quarters. For example, we see fewer mergers and more equity funding for transactions, as well as slowing shareholder rewards in part because both mergers and enhancements are at records and at unsustainable levels.1 Our research analysts have recently shifted credit outlooks to stable from negative in the Pharmaceutical, Healthcare and Food and Beverage sectors, an indication that we expect stable credit fundamentals over the next 12-18 months in those sectors.
CALLING THE CREDIT CYCLE Nearing a Trough While we think it is premature to call a turn in the corporate credit cycle, we believe we are getting closer to the end of a lengthy declining credit phase. Still-elevated share-buyback activity at the potential expense of capital spending indicates a short-term focus and accounting risk, and antitrust issues seem to be growing. But M&A may have peaked and the pace of decline may be slowing. For instance, a balance sheet focus is now evident in Energy and Mining sectors, where dividend cuts, equity issuance and debt reduction are prevailing,2 which along with a rally in commodities, has contributed to spread tightening. If a deleveraging trend were to become more common across other sectors, it would give us greater conviction that the credit cycle had turned. Current debt-tocash flow metrics are historically high. For example, median leverage for the IG market touched 2.8x at 4Q15, matching prior recessionary peaks in 4Q09 and 2Q09.3 At a certain point, rating agency downgrades, bond spread widening and shareholder concerns will probably provide enough incentive for management 1
Q1 2016 CORPORATE BOND COMMENTARY teams to refocus on the virtues of financial flexibility and a strong balance sheet. at a Slower Figure 1: DecliningDeclining at a Slower Pace Pace
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
• Event Risk: We upgraded our assessment of this driver from moderate weakness to modest weakness. We expect M&A and activist event-driven risk to slow in 2016 relative to the record prior year and become slightly less of a headwind for credit.
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
• Industrials Leverage: We upgraded our assessment of this driver from moderate weakness to modest weakness. Gross leverage in the IG market is at its highest point in the past 15 years.5 We do not think leverage will go much higher than it is.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
CREDIT TRENDS DASHBOARD Shareholder-Friendly Activity May Have Peaked 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. We made four adjustments to our dashboard this quarter. Overall, we see IG corporate credit fundamentals as nearing a trough.
Corporate Credit Trends Dashboard Figure 2: Credit Trends Dashboard Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Oil / Commodities Fund Flows / Technicals Geopolitical Risk Economy (Non-U.S.) Event Risk Industrials' Leverage Credit Rating Trends Corporate Profits
credits, while low oil prices have benefited the consumer and input costs for certain sectors.
Change Since Last Quarter
X X X X X X X X X X
• Capital Sources: We upgraded our assessment of this driver from moderate weakness to modest weakness. High debt is partly offset by solid liquidity and cuts to dividends, and buybacks in commodity sectors indicate a renewed balance sheet focus.6
STRENGTH: BANKS PREPARED FOR LOAN LOSSES Strong Capital and Liquidity Coverage Ratios U.S. bank capital relative to nonperforming loans is at its highest point in the past 20 years. Robust capital levels are a key credit strength, with loan losses likely to rise from cyclical lows. Regulators and authorities have been aggressive in banking, which has driven both higher capital requirements and litigation expenses. Energy exposure, low interest rates and market volatility are expected to weigh on bank earnings. High Capital Cushion vs. Probable Loan Losses
Figure 3: High Capital Cushion vs. Probable Loan Losses 8%
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Summary
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Source: Breckinridge
Key credit drivers that changed during the quarter: • Oil/Commodities: We introduce this driver to the dashboard as a modest weakness. A rebound in oil prices in 1Q164 staunched an economic free fall for Energy
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Operating Trends Capital Sources Management / ESG Risks
Tangible Common Equity / Tangible Assets (lhs) Nonperforming Loans / Total Loans (lhs) Tangible Common Equity / NPLs (rhs) Source: FDIC
STRENGTH: STABILITY IN DOMESTICFOCUSED SECTORS Consumer-Oriented Companies Doing Fine Consumer-facing sectors delivered solid 4Q15 results, while earnings per share for the S&P 500 was -5.1 percent 2
Q1 2016 CORPORATE BOND COMMENTARY year over year. Consumer discretionary spending on housing and automobiles is benefiting Consumer Cyclical sectors, home retailers and auto original equipment manufacturers (OEMs), and Consumer Discretionary earnings were up 9.2 percent. Expense reductions and lower input costs are helping some Consumer Staples companies, although earnings were flat. Healthcare continues to outperform, with earnings up 11 percent. For 1Q16, EPS may decline 8.7 percent, which would be the fourth quarter in a row of declines.7 Corporate Earnings Growth by Sector Figure 4: Corporate Earnings Growth by Sector 40% 20%
Growth in capital expenditures has recently flatlined while share buybacks and common dividends have been running at record levels. Unsustainable shareholder enhancements at the potential expense of long-term capital investment may increase bondholder risk since these enhancements obviously do not generate sales or cash flow to service debt. Admittedly, capex has risen steadily since the trough in 2009.9 In addition, enhancement cuts in energy and mining suggest a nascent balance sheet focus although capex has also been reduced. Figure 6: Short-Termism and and Long-Term Short-Termism Long-TermRisk Risk
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S&P 500 Index EPS Growth (4Q15, YoY%) Source: Bloomberg, S&P 500 Index, Breckinridge Capital Advisors
$ Billions
6.5%
-80%
700
6.0%
600 5.5% 500 400
5.0% 2006
WEAKNESS: GROSS LEVERAGE HIGHEST SINCE CRISIS High Debt a Risk for Bondholders
2007
2008
2009
2010
2011
2012
2013
2014
2015
S&P 500 Index Gross Buybacks + Dividends S&P 500 Index Capital Expenditures (excluding Financials) S&P 500 Index Capital Expenditures / Sales (rhs) Source: Bloomberg, SIFMA
Debt growth for the IG cohort has exceeded growth in operating cash flows for several quarters. Leverage for the market touched 2.8x at 4Q15, its highest point since the peaks in 4Q09 and 2Q02. Not surprisingly, the largest increase in leverage at a sector level was in Energy (up to 3.0x from 2.0x) while Consumer Products (1.8x) declined. However, excluding the Energy and Basic Industry sectors, IG leverage declined slightly on deleveraging post-M&A.8 We expect this theme to continue over the coming quarters. Figure 5: Leverage Rose totoSix-Year Leverage Rose Six-YearHigh Highin inQ415 4Q15 3.0x Peak Leverage during Cycle
WEAKNESS: ENHANCEMENTS TRUMPING INVESTMENT Capex Flatlines with Record Enhancements
SUMMARY: SECTOR OUTLOOKS Divergence in Credit Fundamentals Our research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and ESG drivers are evaluated through rigorous analysis. Our analyst sector outlooks and relative value assessments inform our investment committee as it formulates strategy and sets risk exposures for sectors within the corporate allocation of our Government Credit strategies. In the table below, our analysts have identified three corporate sectors with fundamentals that are stable to positive and three sectors with negative trends. Figure 7: Sector Outlooks
2.5x
Stable/Positive Outlook
2.0x
1.5x 2Q02
4Q09
4Q15
Gross Leverage
- Solid capital and liquidity coverage ratios - Adequate earnings with lower litigation
Consumer Non-Cyclical
- Good increase in Pharma product pipeline - Cost cuts driving food/beverage margins
Median (00-15)
Cycle
Gross Leverage (excluding Energy, Metals) Source: J.P. Morgan, Morgan Stanley
Key Sector Drivers
U.S. Banks
Consumer Cyclical Negative Outlook
- Solid U.S. housing market and auto sales Key Sector Drivers
Insurance
- Low rates impacting investment income
Basic Industry
- Slowdown in China weighing on base metals - Credit metrics may face further deterioration
REITs
- High leverage compared to other sectors
3
Stable/Positive Outlook
Key Sector Drivers
U.S. Banks
- Solid capital and liquidity coverage ratios - Adequate earnings with lower litigation
Consumer Non-Cyclical
- Good increase in Pharma product pipeline
- Cost cuts driving food/beverage margins Q1 2016 CORPORATE BOND COMMENTARY Consumer Cyclical
Negative Outlook
- Solid U.S. housing market and auto sales
Figure 9: Returns by Sector Returns by Sector
Key Sector Drivers
Insurance
- Low rates impacting investment income
Basic Industry
- Slowdown in China weighing on base metals - Credit metrics may face further deterioration
REITs
- High leverage compared to other sectors - Commercial real estate prices may soften
6% 5% 4% 3% 2% 1%
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12 to 18 months.
0% -1%
CORPORATE MARKET RETURNS A Tale of Two Halves Due primarily to a significant decline in Treasury bond yields in 1Q16, the total return for the intermediate IG corporate bond market was a notable 2.76 percent in the first quarter, Barclays data showed. Compared to duration-neutral Treasuries, the intermediate market generated 17 basis points (bps) of excess return coupon income and 3bps of spread tightening in 1Q16.10 It was risk-off in the first half of the quarter, and AAA corporate bonds outperformed the corporate market by 216bps. There was a sharp reversal in the second half of 1Q16, and BBB corporate bonds outperformed the market excess return by 78bps.11 Excessby Returns Figure 8: Excess Returns Ratingby Rating 4% 3% 2%
Ba si c Co Com Ind ns us m um u tr er nica y Co No tio ns n ns um cyc er lica Cy l Te clic a Tr chn l an o sp log y o Ca rta t pi ta ion lG oo Co ds rp Ut or ili at ty e Ot he Ma rk rI nd et us tr ia Ot l E ne he r F rg y in an Fi ci na al nc Ba nk e Co in g m pa ni es RE Br IT ok I er nsu S r s/ As anc se e tM gr s
-2%
Total Return Excess Return Source: Barclays Intermediate Corporate Index
MARKET TECHNICAL: FUND FLOWS AND RELATIVE SPREADS Bond Inflows Were Modest in 1Q16 Taxable bond mutual funds reported modest net inflows of $1.6 billion in 1Q16.14 Flows recovered in March and IG bond funds brought in $11 billion as risk sentiment improved. Fund flows have been volatile over the past three years and remain a risk to the market. Bond market liquidity is also a concern, with a higher rate of repo failures, low bond trading turnover and pressure on large bank Fixed Income Clearing Corporation (FICC) operations. Figure 10: Bond Mutual Fund Flows
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AAA Corp.
AA Corp.
A Corp.
BBB Corp.
Market
12/31/15 - 2/12/16 2/13/16 - 3/31/16 1Q16 Source: Barclays Intermediate Corporate Index
Returns Favor Basics and Services Driven by the Metals and Mining sector, Basic Industries notably outperformed during the quarter on, among other factors, a recovery in iron ore prices and on dividend cuts by major producers such as BHP Billiton Plc and Rio Tinto Plc.12 Consumer Cyclical sectors including home retailers and auto companies, among others, did well on favorable exposure to the U.S. economy compared to weakness overseas. Banks and other Financials underperformed on concerns due to energy exposures, capital markets volatility and low interest rates.13
$ Millions
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Jan-14
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Jan-16
Total Taxable Bonds Investment Grade Source: ICI, Lipper
U.S. Corporate Spread Pickup While not historically uncommon, current U.S. IG corporate bond spreads are slightly wide relative to IG Euro-currency corporates and significantly wider than Yen-denominated IG corporates. The current nominal yield differential in these markets is also high, with U.S. corporates yielding 3.2 percent, Europe at 1.1 percent and Japan at 0.2 percent 4
Q1 2016 CORPORATE BOND COMMENTARY at the end of 1Q16.15 The ECB decision to buy non-financial IG euro-currency corporates seems likely to keep spreads relatively tight in Europe and may have a spillover effect into the U.S. market. While the Fed’s accommodative monetary policy is expected to slowly tighten, the ECB and the BoJ remain extraordinarily accommodative. Figure 11: IG Corporate Regional Comparison IG Corporate RegionalSpread Spread Comparison 200
OAS (bps)
150
100
50
Steady Issuance and M&A Volume New U.S. IG corporate bond issuance of $356 billion in 1Q16 was in line with 1Q15 levels.18 Financials dominated new issuance at 45 percent of the primary market by volume, based partly on expected TLAC requirements and refinancing activity. The Consumer Staples sector was 15 percent of total volume due primarily to the $46 billion A-B InBev bond issuance to pre-fund its merger with SAB Miller.19 U.S. M&A volume of $480 billion was flat in 1Q16 compared to the prior year. However, M&A activity was down 42 percent compared to 4Q15.20 We now expect M&A to decline in 2016 on tighter financial conditions and antitrust issues compared to record M&A in 2015. Figure 13: New IGNew Issuance and and M&A Value IG Issuance M&A Value
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BAML USD Corporate Bond Index BAML Euro Corporate Bond Index BAML Japan Corporate Bond Index Source: SIFMA, FINRA, Thomson Reuters, TRACE, Bank of America Merrill Lynch
$ Billions
600
Corporate Bond Spread Volatility
Figure 12: IG Intermediate Corporate Spread IG Intermediate Corporate Spread 200 180 160 140 120 100 80
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In a volatile period, intermediate IG corporate spreads tightened 3bps, ending 1Q16 at an OAS of 136bps.16 Spreads peaked at an OAS of 188bps in mid-February but fully retraced that move by late March. Historically, IG corporate spreads have only exceeded 200bps temporarily, during periods of economic recession and/or financial dislocations. Over the past month, Energy and Metals have seen the most dramatic declines in credit spreads. The quality spread between AA and BBB corporates has come back down to the lowest levels since December 2015. While tighter, IG spreads are 60bps wider than June 2014 and value can still be found.17
Source: Barclays
800
1Q16
100 0
1Q15
2Q15
3Q15
4Q15
1Q16
Corporate Bond Issuance U.S. Mergers & Acquisitions Source: Bloomberg
BRECKINRIDGE STRATEGY Tactically Increased Corporates From a strategy perspective, the investment committee increased the corporate allocation target in our Government Credit portfolios from 40 percent to 45 percent in February and reduced the federal government security allocation from 30 percent to 25 percent. This was not a significant move given prior positioning. The change was opportunistic and based on the attractive relative valuation of high-grade corporate bonds. From a fundamental perspective, while it is too early to call a turn in the credit cycle we believe we are getting closer to the end of a lengthy declining credit phase. We are targeting an overweight to AA and A rated corporates relative to our benchmark. We remain underweight BBB bonds, but we are actively monitoring this position, and we maintain agility to make strategic BBB selections. While IG corporate bond spreads finished 1Q16 almost 50bps tighter than the wides achieved in mid-February, they are 60bps wider than June 2014 and value can still be found, particularly in Financials, which have underperformed year-to-date.
5
Q1 2016 CORPORATE BOND COMMENTARY
FOOTNOTES: 1. Dealogic, as of December 28, 2015. In 2015, global M&A volume surpassed $5 trillion for the first year ever. Moody’s, as of November 10, 2015. “Shareholder Activism 2015: North American Non-Financial Corporates.” 2. Company filings, 2015 and 2016. 3. J.P. Morgan, High Grade Credit Fundamentals, March 4, 2016. 4. Bloomberg, as of March 2016. 5. Barclays, U.S. Credit Focus, as of November 20, 2015.
6. FactSet Cash & Investment, S&P 500 Ex-Financials, as
of March 21, 2016. 7. FactSet, as of March and April, 2016. 8. See J.P. Morgan, High Grade Credit Fundamentals, March 4, 2016. 9. FactSet, as of March 21, 2016. 10. Barclays, as of March 31, 2016. 11. Barclays, as of March 31, 2016. 12. BHP Billiton as of February 23, 2016; Rio Tinto as of February 11, 2016. 13. Barclays, as of March 31, 2016.
14. See ICI.org/research/stats. 15. Bloomberg, as of March 31, 2016. 16. Barclays U.S. Corporate Intermediate Investment
Grade Index, referring to Option Adjusted Spread, as of March 31, 2016. 17. Barclays, as of March 31, 2016. 18. Thomson Reuters, as of March 2016. 19. A-B InBev bond prospectus, as of January 15, 2016. 20. Bloomberg, as of March 31, 2016.
DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Breckinridge can make no assurances, warranties or representations that any strategies described will meet their investment objectives or incur any profits.This document may include projections or other forward-looking statements, which are based on Breckinridge’s research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (“third party content”). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.
6
Q1 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Corporate credit cycle may be
nearing a trough. M&A may have peaked and in Energy and Mining sectors, dividend cuts, equity issuance and debt reduction prevail.
• Shareholder-friendly activity
may have peaked. Rating agency downgrades, bond spread widening and shareholder concerns incentivize management teams to refocus on financial flexibility and a strong balance sheet.
• High debt leverage is still a risk for bondholders.
• For U.S. banks, robust capital levels are a key credit strength.
INVESTMENT OUTLOOK Credit Fundamentals May Be Bottoming Spring came early on the East Coast of the U.S. this year, with green shoots visible in March both on the ground and in the investment grade (IG) corporate bond market. Moderate growth in consumer spending, employment and bank lending are supportive of domestic economic activity. In prior Corporate Bond Commentaries, we have highlighted the releveraging by IG corporate borrowers and what has at times seemed like an excessive focus on near-term shareholder enhancements, which in some cases have negatively impacted balance sheets and credit quality. At the moment, earnings are weak, indebtedness is nearing a cyclical peak and the agencies are downgrading credit ratings more often. However, while global economic activity, central bank policy and management actions are wild cards, we think balance sheets may begin to improve over the next several quarters. For example, we see fewer mergers and more equity funding for transactions, as well as slowing shareholder rewards in part because both mergers and enhancements are at records and at unsustainable levels.1 Our research analysts have recently shifted credit outlooks to stable from negative in the Pharmaceutical, Healthcare and Food and Beverage sectors, an indication that we expect stable credit fundamentals over the next 12-18 months in those sectors.
CALLING THE CREDIT CYCLE Nearing a Trough While we think it is premature to call a turn in the corporate credit cycle, we believe we are getting closer to the end of a lengthy declining credit phase. Still-elevated share-buyback activity at the potential expense of capital spending indicates a short-term focus and accounting risk, and antitrust issues seem to be growing. But M&A may have peaked and the pace of decline may be slowing. For instance, a balance sheet focus is now evident in Energy and Mining sectors, where dividend cuts, equity issuance and debt reduction are prevailing,2 which along with a rally in commodities, has contributed to spread tightening. If a deleveraging trend were to become more common across other sectors, it would give us greater conviction that the credit cycle had turned. Current debt-tocash flow metrics are historically high. For example, median leverage for the IG market touched 2.8x at 4Q15, matching prior recessionary peaks in 4Q09 and 2Q09.3 At a certain point, rating agency downgrades, bond spread widening and shareholder concerns will probably provide enough incentive for management 1
Q1 2016 CORPORATE BOND COMMENTARY teams to refocus on the virtues of financial flexibility and a strong balance sheet. at a Slower Figure 1: DecliningDeclining at a Slower Pace Pace
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
• Event Risk: We upgraded our assessment of this driver from moderate weakness to modest weakness. We expect M&A and activist event-driven risk to slow in 2016 relative to the record prior year and become slightly less of a headwind for credit.
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
• Industrials Leverage: We upgraded our assessment of this driver from moderate weakness to modest weakness. Gross leverage in the IG market is at its highest point in the past 15 years.5 We do not think leverage will go much higher than it is.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
CREDIT TRENDS DASHBOARD Shareholder-Friendly Activity May Have Peaked 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. We made four adjustments to our dashboard this quarter. Overall, we see IG corporate credit fundamentals as nearing a trough.
Corporate Credit Trends Dashboard Figure 2: Credit Trends Dashboard Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Oil / Commodities Fund Flows / Technicals Geopolitical Risk Economy (Non-U.S.) Event Risk Industrials' Leverage Credit Rating Trends Corporate Profits
credits, while low oil prices have benefited the consumer and input costs for certain sectors.
Change Since Last Quarter
X X X X X X X X X X
• Capital Sources: We upgraded our assessment of this driver from moderate weakness to modest weakness. High debt is partly offset by solid liquidity and cuts to dividends, and buybacks in commodity sectors indicate a renewed balance sheet focus.6
STRENGTH: BANKS PREPARED FOR LOAN LOSSES Strong Capital and Liquidity Coverage Ratios U.S. bank capital relative to nonperforming loans is at its highest point in the past 20 years. Robust capital levels are a key credit strength, with loan losses likely to rise from cyclical lows. Regulators and authorities have been aggressive in banking, which has driven both higher capital requirements and litigation expenses. Energy exposure, low interest rates and market volatility are expected to weigh on bank earnings. High Capital Cushion vs. Probable Loan Losses
Figure 3: High Capital Cushion vs. Probable Loan Losses 8%
1000%
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500% 400%
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X X
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Summary
100%
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Source: Breckinridge
Key credit drivers that changed during the quarter: • Oil/Commodities: We introduce this driver to the dashboard as a modest weakness. A rebound in oil prices in 1Q164 staunched an economic free fall for Energy
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Operating Trends Capital Sources Management / ESG Risks
Tangible Common Equity / Tangible Assets (lhs) Nonperforming Loans / Total Loans (lhs) Tangible Common Equity / NPLs (rhs) Source: FDIC
STRENGTH: STABILITY IN DOMESTICFOCUSED SECTORS Consumer-Oriented Companies Doing Fine Consumer-facing sectors delivered solid 4Q15 results, while earnings per share for the S&P 500 was -5.1 percent 2
Q1 2016 CORPORATE BOND COMMENTARY year over year. Consumer discretionary spending on housing and automobiles is benefiting Consumer Cyclical sectors, home retailers and auto original equipment manufacturers (OEMs), and Consumer Discretionary earnings were up 9.2 percent. Expense reductions and lower input costs are helping some Consumer Staples companies, although earnings were flat. Healthcare continues to outperform, with earnings up 11 percent. For 1Q16, EPS may decline 8.7 percent, which would be the fourth quarter in a row of declines.7 Corporate Earnings Growth by Sector Figure 4: Corporate Earnings Growth by Sector 40% 20%
Growth in capital expenditures has recently flatlined while share buybacks and common dividends have been running at record levels. Unsustainable shareholder enhancements at the potential expense of long-term capital investment may increase bondholder risk since these enhancements obviously do not generate sales or cash flow to service debt. Admittedly, capex has risen steadily since the trough in 2009.9 In addition, enhancement cuts in energy and mining suggest a nascent balance sheet focus although capex has also been reduced. Figure 6: Short-Termism and and Long-Term Short-Termism Long-TermRisk Risk
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S&P 500 Index EPS Growth (4Q15, YoY%) Source: Bloomberg, S&P 500 Index, Breckinridge Capital Advisors
$ Billions
6.5%
-80%
700
6.0%
600 5.5% 500 400
5.0% 2006
WEAKNESS: GROSS LEVERAGE HIGHEST SINCE CRISIS High Debt a Risk for Bondholders
2007
2008
2009
2010
2011
2012
2013
2014
2015
S&P 500 Index Gross Buybacks + Dividends S&P 500 Index Capital Expenditures (excluding Financials) S&P 500 Index Capital Expenditures / Sales (rhs) Source: Bloomberg, SIFMA
Debt growth for the IG cohort has exceeded growth in operating cash flows for several quarters. Leverage for the market touched 2.8x at 4Q15, its highest point since the peaks in 4Q09 and 2Q02. Not surprisingly, the largest increase in leverage at a sector level was in Energy (up to 3.0x from 2.0x) while Consumer Products (1.8x) declined. However, excluding the Energy and Basic Industry sectors, IG leverage declined slightly on deleveraging post-M&A.8 We expect this theme to continue over the coming quarters. Figure 5: Leverage Rose totoSix-Year Leverage Rose Six-YearHigh Highin inQ415 4Q15 3.0x Peak Leverage during Cycle
WEAKNESS: ENHANCEMENTS TRUMPING INVESTMENT Capex Flatlines with Record Enhancements
SUMMARY: SECTOR OUTLOOKS Divergence in Credit Fundamentals Our research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and ESG drivers are evaluated through rigorous analysis. Our analyst sector outlooks and relative value assessments inform our investment committee as it formulates strategy and sets risk exposures for sectors within the corporate allocation of our Government Credit strategies. In the table below, our analysts have identified three corporate sectors with fundamentals that are stable to positive and three sectors with negative trends. Figure 7: Sector Outlooks
2.5x
Stable/Positive Outlook
2.0x
1.5x 2Q02
4Q09
4Q15
Gross Leverage
- Solid capital and liquidity coverage ratios - Adequate earnings with lower litigation
Consumer Non-Cyclical
- Good increase in Pharma product pipeline - Cost cuts driving food/beverage margins
Median (00-15)
Cycle
Gross Leverage (excluding Energy, Metals) Source: J.P. Morgan, Morgan Stanley
Key Sector Drivers
U.S. Banks
Consumer Cyclical Negative Outlook
- Solid U.S. housing market and auto sales Key Sector Drivers
Insurance
- Low rates impacting investment income
Basic Industry
- Slowdown in China weighing on base metals - Credit metrics may face further deterioration
REITs
- High leverage compared to other sectors
3
Stable/Positive Outlook
Key Sector Drivers
U.S. Banks
- Solid capital and liquidity coverage ratios - Adequate earnings with lower litigation
Consumer Non-Cyclical
- Good increase in Pharma product pipeline
- Cost cuts driving food/beverage margins Q1 2016 CORPORATE BOND COMMENTARY Consumer Cyclical
Negative Outlook
- Solid U.S. housing market and auto sales
Figure 9: Returns by Sector Returns by Sector
Key Sector Drivers
Insurance
- Low rates impacting investment income
Basic Industry
- Slowdown in China weighing on base metals - Credit metrics may face further deterioration
REITs
- High leverage compared to other sectors - Commercial real estate prices may soften
6% 5% 4% 3% 2% 1%
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12 to 18 months.
0% -1%
CORPORATE MARKET RETURNS A Tale of Two Halves Due primarily to a significant decline in Treasury bond yields in 1Q16, the total return for the intermediate IG corporate bond market was a notable 2.76 percent in the first quarter, Barclays data showed. Compared to duration-neutral Treasuries, the intermediate market generated 17 basis points (bps) of excess return coupon income and 3bps of spread tightening in 1Q16.10 It was risk-off in the first half of the quarter, and AAA corporate bonds outperformed the corporate market by 216bps. There was a sharp reversal in the second half of 1Q16, and BBB corporate bonds outperformed the market excess return by 78bps.11 Excessby Returns Figure 8: Excess Returns Ratingby Rating 4% 3% 2%
Ba si c Co Com Ind ns us m um u tr er nica y Co No tio ns n ns um cyc er lica Cy l Te clic a Tr chn l an o sp log y o Ca rta t pi ta ion lG oo Co ds rp Ut or ili at ty e Ot he Ma rk rI nd et us tr ia Ot l E ne he r F rg y in an Fi ci na al nc Ba nk e Co in g m pa ni es RE Br IT ok I er nsu S r s/ As anc se e tM gr s
-2%
Total Return Excess Return Source: Barclays Intermediate Corporate Index
MARKET TECHNICAL: FUND FLOWS AND RELATIVE SPREADS Bond Inflows Were Modest in 1Q16 Taxable bond mutual funds reported modest net inflows of $1.6 billion in 1Q16.14 Flows recovered in March and IG bond funds brought in $11 billion as risk sentiment improved. Fund flows have been volatile over the past three years and remain a risk to the market. Bond market liquidity is also a concern, with a higher rate of repo failures, low bond trading turnover and pressure on large bank Fixed Income Clearing Corporation (FICC) operations. Figure 10: Bond Mutual Fund Flows
1%
Bond Mutual Fund Flows
0% -1%
20000
-2%
10000
-3%
0
AAA Corp.
AA Corp.
A Corp.
BBB Corp.
Market
12/31/15 - 2/12/16 2/13/16 - 3/31/16 1Q16 Source: Barclays Intermediate Corporate Index
Returns Favor Basics and Services Driven by the Metals and Mining sector, Basic Industries notably outperformed during the quarter on, among other factors, a recovery in iron ore prices and on dividend cuts by major producers such as BHP Billiton Plc and Rio Tinto Plc.12 Consumer Cyclical sectors including home retailers and auto companies, among others, did well on favorable exposure to the U.S. economy compared to weakness overseas. Banks and other Financials underperformed on concerns due to energy exposures, capital markets volatility and low interest rates.13
$ Millions
-4%
-10000 -20000 -30000 -40000
Jan-14
May-14
Sep-14
Jan-15
May-15
Sep-15
Jan-16
Total Taxable Bonds Investment Grade Source: ICI, Lipper
U.S. Corporate Spread Pickup While not historically uncommon, current U.S. IG corporate bond spreads are slightly wide relative to IG Euro-currency corporates and significantly wider than Yen-denominated IG corporates. The current nominal yield differential in these markets is also high, with U.S. corporates yielding 3.2 percent, Europe at 1.1 percent and Japan at 0.2 percent 4
Q1 2016 CORPORATE BOND COMMENTARY at the end of 1Q16.15 The ECB decision to buy non-financial IG euro-currency corporates seems likely to keep spreads relatively tight in Europe and may have a spillover effect into the U.S. market. While the Fed’s accommodative monetary policy is expected to slowly tighten, the ECB and the BoJ remain extraordinarily accommodative. Figure 11: IG Corporate Regional Comparison IG Corporate RegionalSpread Spread Comparison 200
OAS (bps)
150
100
50
Steady Issuance and M&A Volume New U.S. IG corporate bond issuance of $356 billion in 1Q16 was in line with 1Q15 levels.18 Financials dominated new issuance at 45 percent of the primary market by volume, based partly on expected TLAC requirements and refinancing activity. The Consumer Staples sector was 15 percent of total volume due primarily to the $46 billion A-B InBev bond issuance to pre-fund its merger with SAB Miller.19 U.S. M&A volume of $480 billion was flat in 1Q16 compared to the prior year. However, M&A activity was down 42 percent compared to 4Q15.20 We now expect M&A to decline in 2016 on tighter financial conditions and antitrust issues compared to record M&A in 2015. Figure 13: New IGNew Issuance and and M&A Value IG Issuance M&A Value
0
900 1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
700
BAML USD Corporate Bond Index BAML Euro Corporate Bond Index BAML Japan Corporate Bond Index Source: SIFMA, FINRA, Thomson Reuters, TRACE, Bank of America Merrill Lynch
$ Billions
600
Corporate Bond Spread Volatility
Figure 12: IG Intermediate Corporate Spread IG Intermediate Corporate Spread 200 180 160 140 120 100 80
6
16
ar -1 M
nJa
ov -
15
15 N
pSe
5
Ju l15
ay -1 M
15
ar -1 5 M
nJa
ov -1 4 N
14 pSe
l-
14
60
Ju
OAS (bps)
500 400 300 200
In a volatile period, intermediate IG corporate spreads tightened 3bps, ending 1Q16 at an OAS of 136bps.16 Spreads peaked at an OAS of 188bps in mid-February but fully retraced that move by late March. Historically, IG corporate spreads have only exceeded 200bps temporarily, during periods of economic recession and/or financial dislocations. Over the past month, Energy and Metals have seen the most dramatic declines in credit spreads. The quality spread between AA and BBB corporates has come back down to the lowest levels since December 2015. While tighter, IG spreads are 60bps wider than June 2014 and value can still be found.17
Source: Barclays
800
1Q16
100 0
1Q15
2Q15
3Q15
4Q15
1Q16
Corporate Bond Issuance U.S. Mergers & Acquisitions Source: Bloomberg
BRECKINRIDGE STRATEGY Tactically Increased Corporates From a strategy perspective, the investment committee increased the corporate allocation target in our Government Credit portfolios from 40 percent to 45 percent in February and reduced the federal government security allocation from 30 percent to 25 percent. This was not a significant move given prior positioning. The change was opportunistic and based on the attractive relative valuation of high-grade corporate bonds. From a fundamental perspective, while it is too early to call a turn in the credit cycle we believe we are getting closer to the end of a lengthy declining credit phase. We are targeting an overweight to AA and A rated corporates relative to our benchmark. We remain underweight BBB bonds, but we are actively monitoring this position, and we maintain agility to make strategic BBB selections. While IG corporate bond spreads finished 1Q16 almost 50bps tighter than the wides achieved in mid-February, they are 60bps wider than June 2014 and value can still be found, particularly in Financials, which have underperformed year-to-date.
5
Q1 2016 CORPORATE BOND COMMENTARY
FOOTNOTES: 1. Dealogic, as of December 28, 2015. In 2015, global M&A volume surpassed $5 trillion for the first year ever. Moody’s, as of November 10, 2015. “Shareholder Activism 2015: North American Non-Financial Corporates.” 2. Company filings, 2015 and 2016. 3. J.P. Morgan, High Grade Credit Fundamentals, March 4, 2016. 4. Bloomberg, as of March 2016. 5. Barclays, U.S. Credit Focus, as of November 20, 2015.
6. FactSet Cash & Investment, S&P 500 Ex-Financials, as
of March 21, 2016. 7. FactSet, as of March and April, 2016. 8. See J.P. Morgan, High Grade Credit Fundamentals, March 4, 2016. 9. FactSet, as of March 21, 2016. 10. Barclays, as of March 31, 2016. 11. Barclays, as of March 31, 2016. 12. BHP Billiton as of February 23, 2016; Rio Tinto as of February 11, 2016. 13. Barclays, as of March 31, 2016.
14. See ICI.org/research/stats. 15. Bloomberg, as of March 31, 2016. 16. Barclays U.S. Corporate Intermediate Investment
Grade Index, referring to Option Adjusted Spread, as of March 31, 2016. 17. Barclays, as of March 31, 2016. 18. Thomson Reuters, as of March 2016. 19. A-B InBev bond prospectus, as of January 15, 2016. 20. Bloomberg, as of March 31, 2016.
DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Breckinridge can make no assurances, warranties or representations that any strategies described will meet their investment objectives or incur any profits.This document may include projections or other forward-looking statements, which are based on Breckinridge’s research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (“third party content”). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.
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