q1 2017 corporate bond commentary
COMMENTARY
Q1 2017 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Debt leverage, share buybacks and
merger activity are notably high and indicative of late credit cycle behavior.
• Corporate profits are forecast
to grow in 2017, providing for some steadying of weak credit fundamentals.
• There is steady demand for U.S. corporate bonds from domestic and foreign investors seeking higher yields.
Investment Outlook A Challenging Credit Backdrop Several key positives continue to support the outlook for the U.S. investmentgrade (IG) corporate bond market. The relative outperformance of the U.S. economy remains an important strength, and while U.S. real GDP growth was somewhat sluggish at 2.1 percent in 4Q16, consumption grew by 3.5 percent and manufacturing and job growth data continues to look solid. Low financial leverage in the U.S. banking system is another material strength for the IG corporate market, and net interest income should pick up if interest rates continue to move higher. Furthermore, after a profits recession that was also characterized by anemic revenue growth, S&P 500 companies are now expected to deliver improved operating results and had a good fourth quarter tally, with operating earnings up a solid 6.3 percent year-over-year. Finally, technicals remain constructive. Taxable bond fund inflows were strong at over $100 billion in 1Q17 and foreign purchases of U.S. corporates were over $300 billion in 2016. Clearly there are risks to IG corporate market performance as well. After slowing in 2016, U.S. mergers picked up sharply in 1Q17, with several large proposed mergers a risk to both creditworthiness and technicals (e.g. large M&A-related new supply), which could place upward pressure on spreads. An activist investor disclosed a large position in Procter & Gamble stock, which may embolden other activists to pursue larger IG companies. Regarding geopolitical risks, potentially rising U.S. tension with Iran, Russia, North Korea and China could periodically drive a flight-to-safety trade out of risk assets, which could pressure IG credit spreads. High share buyback activity, ample dividends and weak capital spending are symptomatic of managements’ shorter-term focus. We see some evidence of weaker earnings quality and rising ESG risks and controversies. The IG market’s gross leverage has moved near three times, per S&P, during an economic expansion, which leaves little cushion when an economic recession emerges. With the Federal Reserve currently tightening monetary policy and at least two more Fed rate hikes now expected in 2017, loose monetary policy is no longer a tailwind for IG corporate credit. U.S. government regulatory and fiscal policies may be poised to supplement monetary policy as a tailwind if corporate-friendly policies are implemented. But this is increasingly uncertain, and some policies (e.g. tariffs or a border tax on 1
Q1 2017 CORPORATE BOND COMMENTARY Corporate Credit Trends Dashboard
imports) could be credit negative for specific sectors. In today’s environment, we continue to focus on longterm investing with an emphasis on those high-quality companies that have a firm grasp on the importance of driving innovation and reinvesting into their businesses to grow free cash flows and increase long-term stakeholder value and bondholder creditworthiness.
Weakness Strength WA
Economy (U.S.) Financials' Leverage Regulatory Action Central Bank Accommodation Flows / Technicals Corporate Profits Oil / Commodities Event Risk Credit Rating Trends Geopolitical Risk Industrials' Leverage Economy (Non-U.S.)
Declining Credit Phase
Declining Credit Phase WA
ME
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
Change Since Last Quarter
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
ME
X X X X X X X X X X X X
Summary Operating Trends Capital Sources Management / ESG Risks
t
X X X
Source: Breckinridge Capital Advisors.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Risk: Cash to Debt Below Trend in Most Sectors Liquidity is Below Trend t
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit and the incremental shifts in these drivers from quarter to quarter. We made three adjustments to our dashboard this quarter.
A key strength throughout this IG credit cycle has been high corporate cash liquidity relative to total debt. However, S&P sector-level data shows that several sectors now have liquidity that is below average. While the technology sector is very strong, eight of 10 S&P 500 sectors have cash-todebt levels that are below the index’s 10-year average. With less cash on hand, future merger activity in certain sectors (e.g. Telecom and Real Estate) will need to be financed with incremental capital raises.
Key credit drivers that changed during the quarter:
All Liquidity is Not All Created LiquidityEqual is Not Created Equal
Credit Trends Dashboard Upgrade Regulatory Action and Credit Rating Trends, Downgrade Geopolitical Risk
120%
•• Regulatory Action: We upgraded our assessment of this driver from neutral to modest strength. Potential regulatory relief may reduce compliance costs for U.S. banks, and tax cuts and deregulation could benefit certain industrial sectors.
•• Geopolitical Risk: We downgraded our assessment of this driver from modest weakness to moderate weakness. Potentially rising U.S. tension with Iran, Russia, North Korea and China could periodically drive a “flight-to-safety” trade.
80% 60% 40% 20%
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•• Credit Rating Trends: We upgraded our assessment of this driver from moderate weakness to modest weakness. U.S. IG credit downgrades were elevated in 2016, based mostly on commodities. But the pace of rating downgrades has slowed, per S&P.
100%
t
Cash to Debt (Sector) Cash to Debt (S&P 500, 10-Yr Avg) Source: FactSet, S&P 500 Index, as of 4Q16.
Risk: Gross Debt Leverage is Historically High Comparable to Previous Recessionary Peaks IG-rated companies have steadily added debt leverage since a trough in 2010, per the chart below. Single-A-
2
Q1 2017 CORPORATE BOND COMMENTARY rated issuers have added a half-turn of debt leverage, while BBB issuers have added slightly more. In the recent past, leverage has typically peaked just prior to or during recessions (e.g. 2001 and 2009). With current gross debt leverage comparable to those recessionary periods, it seems reasonable to expect that leverage could peak above that if the U.S. were to enter an unexpected economic recession.
Strength: Corporate EBITDA and Margins Look Solid Profits are Expected to Grow in 2017
2.6x
Over the last few years, subpar U.S. and global economic growth has translated into sluggish revenue expansion for S&P 500 companies. However, growth in EBITDA for 2016 held up slightly better, as many large companies focused on cutting operating costs. Despite the challenging backdrop, company EBITDA margins have remained quite stable (e.g. ranged from 17-19 percent since 2012) and may improve if growth picks up and/or if tax reform were to reduce corporate income tax rates.
2.2x
S&P 500 Index: Higher Margins and Growth
IG Gross Leverage by Rating IG Gross Leverage by Rating
S&P 500 Index: Higher Margins and Growth
25% 1.8x
20% 15%
1.4x
1.0x
10% 5% 1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
0% -5%
t
t
A-Rated BBB-Rated Source: Morgan Stanley Research, Standard & Poor’s.
-10%
Strength: High Bank Capital Augurs for Rating Upside Capital Should Equate to Creditworthiness
t
U.S.Strength Bank Capital Strength andRatings Credit Ratings U.S. Bank Capital and Credit
Tangible Common Equity Ratio
12%
A2/A
2015
2016
2017E
2018E
t
Returns: Good Corporate Market Excess Returns Lower-Quality Bonds Outperformed in 1Q17 The total return for the intermediate IG corporate market was 1.16 percent in the first quarter, per Barclays. However, compared to duration-neutral Treasuries and based on a combination of carry and spread compression, the intermediate IG corporate market generated 54 basis points (bps) of excess return in the first quarter. For the first quarter, BBB-rated corporate bonds outperformed the IG corporate bond market’s excess return by 20bps. In contrast, higher-quality AA-rated corporate bonds underperformed the IG bond market’s excess return by 19bps.
1.4%
A3/A-
1.2%
Aa1/AA+
6%
1.0%
Aa2/AAAa2/AA
0.8% 0.6%
2% 0%
t
Baa1/BBB+
Aa1/AA
2014
Returns by Rating -Returns 1Q17 by Rating – 1Q17
Baa1/BBB+
8%
4%
2013
Revenue Growth EBITDA Growth EBITDA Margin Source: S&P 500 Index, Bloomberg, as of March 31, 2017.
Big U.S. banks rated in the AA bucket prior to the global financial crisis (GFC) are now placed in mid- or lower-A or high-BBB rating categories. Since the GFC, bank capital ratios have moved up sharply, while credit ratings remain far lower. For example, Citigroup was rated Aa1/AA in 2007 when the bank reported a tangible common equity (TCE) ratio of 2.7 percent. Today, Citigroup is rated Baa1/BBB+ and the bank reported a TCE ratio of 10.2 percent in 2016. High U.S. bank capital argues for credit ratings upside and is a positive offset to high industrial leverage.
10%
2012
0.4%
Citigroup
Bank of America
Wells Fargo
JPMorgan
0.2% 0.0% t
Year-End 2007 Year-End 2016 Source: Bloomberg, SEC 10-K filings, as of 4Q16. t
BBB Corporates
IG Corporates
A Corporates
AA Corporates
t
Total Return Excess Return Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
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Q1 2017 CORPORATE BOND COMMENTARY Market Technical: U.S. and Foreign Flows Strong Flows into Taxable and IG Funds in 1Q17
Basics and Finance Led Returns in 1Q17 Basic industry (e.g. Chemicals, Paper, Metals and Mining) sector bonds outperformed the IG corporate market’s excess return by 60bps during the first quarter, based primarily on the stability of base metals prices. Finance sectors (e.g. Brokers, Asset Managers and Insurance) outperformed by 41bps and 22bps, respectively primarily due to a proposal to repeal the Fiduciary Rule, solid equity market returns and the move higher in short-term interest rates in 1Q17. Energy bonds modestly underperformed the market by 7bps based on the oil price decline in 1Q17.
After slowing in late 2016, fund inflows accelerated during the quarter, with taxable bond and exchange-traded funds reporting net inflows of $104 billion in 1Q17. For the last 12 months, investment-grade funds reported inflows of over $100 billion, sustaining a positive technical in the U.S. IG corporate market. High-GradeHigh-Grade Fixed Income Flows Accelerated in 1Q17 After Fixed Income Flows Accelerated in 1Q17 Slowing in Late 2016 After Slowing in Late 2016 $45000 U.S. Fund Flows ($Millions)
Returns by Sector– 1Q17 Returns by Sector - 1Q17 2.0% 1.6% 1.2%
$35000 $25000 $15000 $5000
0.8%
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16
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Another important trend in gauging investor demand is the net purchase of U.S. corporate and foreign bonds by foreign residents. Purchases of U.S. corporate and foreign bonds by foreign residents have been quite strong. In 2016, foreigners bought just over $300 billion of U.S. corporate and foreign bonds, which while strong still represented a decline of about $50 billion from 2015. Elevated U.S. currency hedging costs for foreign investors is an offset that may slow these flows.
Intermediate IG corporate spreads tightened by 6bps in the first quarter to an average option-adjusted spread (OAS) of 97bps—the tightest level since October 2014. Lower-quality BBB corporate spreads tightened 7bps on average during the quarter, compared to AA-rated and A-rated bonds, which tightened by 3bps and 5bps, respectively. The quality spread between AA-rated and BBB-rated corporate bonds ended the quarter at 76bps—the tightest level since October 2014.
Foreign Demand is a Key Theme and Technical for the U.S. Foreign Demand is a Key Theme and Technical Corporate Market for the U.S. Corporate Market
$400
Corporate Spreads
$350 Foreign Flows ($Billions)
Corporate Spreads 300 250 200 150
$300 $250 $200 $150 $100 $50 $0
100
2014 50 ay -1 4 Ju l14 Se p14 N ov -1 4 Ja n15 M ar -1 5 M ay -1 5 Ju l15 Se p15 N ov -1 5 Ja n16 M ar -1 6 M ay -1 6 Ju l16 Se p16 N ov -1 6 Ja n17 M ar -1 7
AA corp. A corp. BBB corp. Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
2015
2016
Net Purchases of U.S. Corporate and Foreign Bond Issues by Foreign Residents Source: Federal Reserve Flow of Funds, as of 4Q16.
4
M
ar -1 M
Ju
6
16 nJu
ay -1 M
6
r1
Ba
Robust Flows from Foreigners into Corporates
Spreads: Some Volatility in Corporate Spreads in 1Q17 Corporate Spreads Continue to Grind Tighter
t
t
Taxable Bond Mutual Funds + ETFs Investment-Grade Bond Funds Source: ICI, as of March 31, 2017.
Total Return Excess Return Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
OAS (bps)
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ria s Br l ok ic In er du s/ s tr As y se tM gr s In su ra nc e Co ns um RE IT er S Cy Co cl m i ca m u l Co ni c rp or atio at ns e M ar Ca ke pi t ta lG oo d Ba s nk in Te g ch no lo Co gy ns En um er er gy N on c yc Tr lic an al sp or ta tio n Ut ili ty
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Q1 2017 CORPORATE BOND COMMENTARY Market Technical: Supply and M&A IG Supply and U.S. Mergers Rose in 1Q17
Summary: Sector Outlooks Divergence in Credit Fundamentals
U.S. IG corporate bond issuance of $417 billion in the first quarter was about 10 percent higher on a year-overyear basis. Financials were 48 percent of supply in 1Q17 followed by Technology (13 percent) and Communications (9 percent). U.S. merger volume of $632 billion in 1Q17 increased by 34 percent year-over-year. With yield on the IG corporate bond index still below 3.5 percent, the low all-in cost of debt has sustained high borrowing to partially fund merger and acquisition activity, shareholder rewards, refinancing and other uses of cash.
Our corporate credit research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and material environmental, social and governance (ESG) factors are evaluated through rigorous analysis. Our corporate analyst sector outlooks 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 corporate analysts have identified three corporate sectors with credit fundamentals and ESG factors that are stableto-positive and three with negative trends.
Low RatesSpurred Have Spurred High Borrowing and Activity Low Rates Have High Borrowing andMerger Merger Activity
$Billions
Focus on Defensive, Higher-Quality Sectors
Focus on Defensive, Higher-Quality Sectors
$3000 $2500
Stable/Positive Outlook
Key Sector Drivers
$2000
U.S. Banks
- Higher rates increase net interest income - Solid capital and liquidity coverage ratios
Pharmaceuticals/ Healthcare
- Strong balance sheets and high margins - Essential service and favorable demographic
Technology
- Strong balance sheets and FCF generation - Solid growth trends in software and cloud
$1500 $1000 $500 $0 LTM16
LTM17
1Q16
1Q17
U.S. IG Corporate Issuance U.S. Mergers & Acquisitions Source: Bloomberg, as of March 31, 2017.
t
t
Market Technical: Global Yields Nominal Yields Favor U.S. Corporate Bonds A sizable nominal yield pickup remains in U.S. IGt corporate relative to European and Japan IG corporates. While purchases are expected to be tapered, European central banks are still buying non-financial euro-denominated IG corporate bonds, actively removing supply and keeping allin yields low. Elevated USD hedging costs for foreigners are an offset to the sizable nominal yield differential, although foreign flows remain strong. Nominal Yield Divergence in Global IG Credit Nominal Yield Divergence in Global IG Credit 4.5% 4.0% 3.5%
Yield-to-Worst
3.0% 2.5% 2.0% 1.5% 1.0% 0.5%
t
7
6
1Q 1
6
3Q 1
5
1Q 1
5
3Q 1
4
1Q 1
4
3Q 1
3
1Q 1
3
3Q 1
2
1Q 1
2
3Q 1
1
1Q 1
3Q 1
1Q 1
1
0.0%
BAML U.S. Corporate Bond Index BAML Euro Corporate Index BAML Japan Corporate Index Source: BofA Merrill Lynch Corporate Indices, as of March 31, 2017.
Negative Outlook
Key Sector Drivers
Food/Beverage & Consumer Products
- Growing pressure from pricing bifurcation - Rise of digital marketing and e-commerce
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
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12-18 months. Source: Breckinridge Capital Advisors.
Breckinridge Strategy Looking Through the Noise We continue to see some positive catalysts in the IG corporate market primarily related to corporate profit growth, potential tax cuts, cash repatriation and deregulation, although we recognize uncertainties surrounding the Trump administration’s fiscal plans and headwinds to effective implementation. However, financial leverage and event risk is high and the possibility of tariffs, trade disputes and geopolitical flare-ups are risks to the market. Considering current valuations and our stated view on the credit cycle, we are continuing to target an overweight to higher-quality AA-rated and A-rated corporates and an underweight to lower-quality BBB corporates within our government credit strategies. In today’s noisy politicized landscape, we believe that management teams of larger, global corporations should focus on long-term strategy and not be swayed by the t
5
Q1 2017 CORPORATE BOND COMMENTARY winds of political change, which may be fickle and relatively short-lived. We continue to focus on investing in the bonds of high-quality companies that have meaningful leverage
and/or credit ratings targets, conservative financial philosophies, an established commitment to innovation and balanced ESG profiles.
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 2017 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Debt leverage, share buybacks and
merger activity are notably high and indicative of late credit cycle behavior.
• Corporate profits are forecast
to grow in 2017, providing for some steadying of weak credit fundamentals.
• There is steady demand for U.S. corporate bonds from domestic and foreign investors seeking higher yields.
Investment Outlook A Challenging Credit Backdrop Several key positives continue to support the outlook for the U.S. investmentgrade (IG) corporate bond market. The relative outperformance of the U.S. economy remains an important strength, and while U.S. real GDP growth was somewhat sluggish at 2.1 percent in 4Q16, consumption grew by 3.5 percent and manufacturing and job growth data continues to look solid. Low financial leverage in the U.S. banking system is another material strength for the IG corporate market, and net interest income should pick up if interest rates continue to move higher. Furthermore, after a profits recession that was also characterized by anemic revenue growth, S&P 500 companies are now expected to deliver improved operating results and had a good fourth quarter tally, with operating earnings up a solid 6.3 percent year-over-year. Finally, technicals remain constructive. Taxable bond fund inflows were strong at over $100 billion in 1Q17 and foreign purchases of U.S. corporates were over $300 billion in 2016. Clearly there are risks to IG corporate market performance as well. After slowing in 2016, U.S. mergers picked up sharply in 1Q17, with several large proposed mergers a risk to both creditworthiness and technicals (e.g. large M&A-related new supply), which could place upward pressure on spreads. An activist investor disclosed a large position in Procter & Gamble stock, which may embolden other activists to pursue larger IG companies. Regarding geopolitical risks, potentially rising U.S. tension with Iran, Russia, North Korea and China could periodically drive a flight-to-safety trade out of risk assets, which could pressure IG credit spreads. High share buyback activity, ample dividends and weak capital spending are symptomatic of managements’ shorter-term focus. We see some evidence of weaker earnings quality and rising ESG risks and controversies. The IG market’s gross leverage has moved near three times, per S&P, during an economic expansion, which leaves little cushion when an economic recession emerges. With the Federal Reserve currently tightening monetary policy and at least two more Fed rate hikes now expected in 2017, loose monetary policy is no longer a tailwind for IG corporate credit. U.S. government regulatory and fiscal policies may be poised to supplement monetary policy as a tailwind if corporate-friendly policies are implemented. But this is increasingly uncertain, and some policies (e.g. tariffs or a border tax on 1
Q1 2017 CORPORATE BOND COMMENTARY Corporate Credit Trends Dashboard
imports) could be credit negative for specific sectors. In today’s environment, we continue to focus on longterm investing with an emphasis on those high-quality companies that have a firm grasp on the importance of driving innovation and reinvesting into their businesses to grow free cash flows and increase long-term stakeholder value and bondholder creditworthiness.
Weakness Strength WA
Economy (U.S.) Financials' Leverage Regulatory Action Central Bank Accommodation Flows / Technicals Corporate Profits Oil / Commodities Event Risk Credit Rating Trends Geopolitical Risk Industrials' Leverage Economy (Non-U.S.)
Declining Credit Phase
Declining Credit Phase WA
ME
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
Change Since Last Quarter
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
ME
X X X X X X X X X X X X
Summary Operating Trends Capital Sources Management / ESG Risks
t
X X X
Source: Breckinridge Capital Advisors.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Risk: Cash to Debt Below Trend in Most Sectors Liquidity is Below Trend t
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit and the incremental shifts in these drivers from quarter to quarter. We made three adjustments to our dashboard this quarter.
A key strength throughout this IG credit cycle has been high corporate cash liquidity relative to total debt. However, S&P sector-level data shows that several sectors now have liquidity that is below average. While the technology sector is very strong, eight of 10 S&P 500 sectors have cash-todebt levels that are below the index’s 10-year average. With less cash on hand, future merger activity in certain sectors (e.g. Telecom and Real Estate) will need to be financed with incremental capital raises.
Key credit drivers that changed during the quarter:
All Liquidity is Not All Created LiquidityEqual is Not Created Equal
Credit Trends Dashboard Upgrade Regulatory Action and Credit Rating Trends, Downgrade Geopolitical Risk
120%
•• Regulatory Action: We upgraded our assessment of this driver from neutral to modest strength. Potential regulatory relief may reduce compliance costs for U.S. banks, and tax cuts and deregulation could benefit certain industrial sectors.
•• Geopolitical Risk: We downgraded our assessment of this driver from modest weakness to moderate weakness. Potentially rising U.S. tension with Iran, Russia, North Korea and China could periodically drive a “flight-to-safety” trade.
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•• Credit Rating Trends: We upgraded our assessment of this driver from moderate weakness to modest weakness. U.S. IG credit downgrades were elevated in 2016, based mostly on commodities. But the pace of rating downgrades has slowed, per S&P.
100%
t
Cash to Debt (Sector) Cash to Debt (S&P 500, 10-Yr Avg) Source: FactSet, S&P 500 Index, as of 4Q16.
Risk: Gross Debt Leverage is Historically High Comparable to Previous Recessionary Peaks IG-rated companies have steadily added debt leverage since a trough in 2010, per the chart below. Single-A-
2
Q1 2017 CORPORATE BOND COMMENTARY rated issuers have added a half-turn of debt leverage, while BBB issuers have added slightly more. In the recent past, leverage has typically peaked just prior to or during recessions (e.g. 2001 and 2009). With current gross debt leverage comparable to those recessionary periods, it seems reasonable to expect that leverage could peak above that if the U.S. were to enter an unexpected economic recession.
Strength: Corporate EBITDA and Margins Look Solid Profits are Expected to Grow in 2017
2.6x
Over the last few years, subpar U.S. and global economic growth has translated into sluggish revenue expansion for S&P 500 companies. However, growth in EBITDA for 2016 held up slightly better, as many large companies focused on cutting operating costs. Despite the challenging backdrop, company EBITDA margins have remained quite stable (e.g. ranged from 17-19 percent since 2012) and may improve if growth picks up and/or if tax reform were to reduce corporate income tax rates.
2.2x
S&P 500 Index: Higher Margins and Growth
IG Gross Leverage by Rating IG Gross Leverage by Rating
S&P 500 Index: Higher Margins and Growth
25% 1.8x
20% 15%
1.4x
1.0x
10% 5% 1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
0% -5%
t
t
A-Rated BBB-Rated Source: Morgan Stanley Research, Standard & Poor’s.
-10%
Strength: High Bank Capital Augurs for Rating Upside Capital Should Equate to Creditworthiness
t
U.S.Strength Bank Capital Strength andRatings Credit Ratings U.S. Bank Capital and Credit
Tangible Common Equity Ratio
12%
A2/A
2015
2016
2017E
2018E
t
Returns: Good Corporate Market Excess Returns Lower-Quality Bonds Outperformed in 1Q17 The total return for the intermediate IG corporate market was 1.16 percent in the first quarter, per Barclays. However, compared to duration-neutral Treasuries and based on a combination of carry and spread compression, the intermediate IG corporate market generated 54 basis points (bps) of excess return in the first quarter. For the first quarter, BBB-rated corporate bonds outperformed the IG corporate bond market’s excess return by 20bps. In contrast, higher-quality AA-rated corporate bonds underperformed the IG bond market’s excess return by 19bps.
1.4%
A3/A-
1.2%
Aa1/AA+
6%
1.0%
Aa2/AAAa2/AA
0.8% 0.6%
2% 0%
t
Baa1/BBB+
Aa1/AA
2014
Returns by Rating -Returns 1Q17 by Rating – 1Q17
Baa1/BBB+
8%
4%
2013
Revenue Growth EBITDA Growth EBITDA Margin Source: S&P 500 Index, Bloomberg, as of March 31, 2017.
Big U.S. banks rated in the AA bucket prior to the global financial crisis (GFC) are now placed in mid- or lower-A or high-BBB rating categories. Since the GFC, bank capital ratios have moved up sharply, while credit ratings remain far lower. For example, Citigroup was rated Aa1/AA in 2007 when the bank reported a tangible common equity (TCE) ratio of 2.7 percent. Today, Citigroup is rated Baa1/BBB+ and the bank reported a TCE ratio of 10.2 percent in 2016. High U.S. bank capital argues for credit ratings upside and is a positive offset to high industrial leverage.
10%
2012
0.4%
Citigroup
Bank of America
Wells Fargo
JPMorgan
0.2% 0.0% t
Year-End 2007 Year-End 2016 Source: Bloomberg, SEC 10-K filings, as of 4Q16. t
BBB Corporates
IG Corporates
A Corporates
AA Corporates
t
Total Return Excess Return Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
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Q1 2017 CORPORATE BOND COMMENTARY Market Technical: U.S. and Foreign Flows Strong Flows into Taxable and IG Funds in 1Q17
Basics and Finance Led Returns in 1Q17 Basic industry (e.g. Chemicals, Paper, Metals and Mining) sector bonds outperformed the IG corporate market’s excess return by 60bps during the first quarter, based primarily on the stability of base metals prices. Finance sectors (e.g. Brokers, Asset Managers and Insurance) outperformed by 41bps and 22bps, respectively primarily due to a proposal to repeal the Fiduciary Rule, solid equity market returns and the move higher in short-term interest rates in 1Q17. Energy bonds modestly underperformed the market by 7bps based on the oil price decline in 1Q17.
After slowing in late 2016, fund inflows accelerated during the quarter, with taxable bond and exchange-traded funds reporting net inflows of $104 billion in 1Q17. For the last 12 months, investment-grade funds reported inflows of over $100 billion, sustaining a positive technical in the U.S. IG corporate market. High-GradeHigh-Grade Fixed Income Flows Accelerated in 1Q17 After Fixed Income Flows Accelerated in 1Q17 Slowing in Late 2016 After Slowing in Late 2016 $45000 U.S. Fund Flows ($Millions)
Returns by Sector– 1Q17 Returns by Sector - 1Q17 2.0% 1.6% 1.2%
$35000 $25000 $15000 $5000
0.8%
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17
16
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Another important trend in gauging investor demand is the net purchase of U.S. corporate and foreign bonds by foreign residents. Purchases of U.S. corporate and foreign bonds by foreign residents have been quite strong. In 2016, foreigners bought just over $300 billion of U.S. corporate and foreign bonds, which while strong still represented a decline of about $50 billion from 2015. Elevated U.S. currency hedging costs for foreign investors is an offset that may slow these flows.
Intermediate IG corporate spreads tightened by 6bps in the first quarter to an average option-adjusted spread (OAS) of 97bps—the tightest level since October 2014. Lower-quality BBB corporate spreads tightened 7bps on average during the quarter, compared to AA-rated and A-rated bonds, which tightened by 3bps and 5bps, respectively. The quality spread between AA-rated and BBB-rated corporate bonds ended the quarter at 76bps—the tightest level since October 2014.
Foreign Demand is a Key Theme and Technical for the U.S. Foreign Demand is a Key Theme and Technical Corporate Market for the U.S. Corporate Market
$400
Corporate Spreads
$350 Foreign Flows ($Billions)
Corporate Spreads 300 250 200 150
$300 $250 $200 $150 $100 $50 $0
100
2014 50 ay -1 4 Ju l14 Se p14 N ov -1 4 Ja n15 M ar -1 5 M ay -1 5 Ju l15 Se p15 N ov -1 5 Ja n16 M ar -1 6 M ay -1 6 Ju l16 Se p16 N ov -1 6 Ja n17 M ar -1 7
AA corp. A corp. BBB corp. Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
2015
2016
Net Purchases of U.S. Corporate and Foreign Bond Issues by Foreign Residents Source: Federal Reserve Flow of Funds, as of 4Q16.
4
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Robust Flows from Foreigners into Corporates
Spreads: Some Volatility in Corporate Spreads in 1Q17 Corporate Spreads Continue to Grind Tighter
t
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Taxable Bond Mutual Funds + ETFs Investment-Grade Bond Funds Source: ICI, as of March 31, 2017.
Total Return Excess Return Source: Bloomberg Barclays U.S. Intermediate IG Corporate Index, as of March 31, 2017.
OAS (bps)
Ap
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Q1 2017 CORPORATE BOND COMMENTARY Market Technical: Supply and M&A IG Supply and U.S. Mergers Rose in 1Q17
Summary: Sector Outlooks Divergence in Credit Fundamentals
U.S. IG corporate bond issuance of $417 billion in the first quarter was about 10 percent higher on a year-overyear basis. Financials were 48 percent of supply in 1Q17 followed by Technology (13 percent) and Communications (9 percent). U.S. merger volume of $632 billion in 1Q17 increased by 34 percent year-over-year. With yield on the IG corporate bond index still below 3.5 percent, the low all-in cost of debt has sustained high borrowing to partially fund merger and acquisition activity, shareholder rewards, refinancing and other uses of cash.
Our corporate credit research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and material environmental, social and governance (ESG) factors are evaluated through rigorous analysis. Our corporate analyst sector outlooks 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 corporate analysts have identified three corporate sectors with credit fundamentals and ESG factors that are stableto-positive and three with negative trends.
Low RatesSpurred Have Spurred High Borrowing and Activity Low Rates Have High Borrowing andMerger Merger Activity
$Billions
Focus on Defensive, Higher-Quality Sectors
Focus on Defensive, Higher-Quality Sectors
$3000 $2500
Stable/Positive Outlook
Key Sector Drivers
$2000
U.S. Banks
- Higher rates increase net interest income - Solid capital and liquidity coverage ratios
Pharmaceuticals/ Healthcare
- Strong balance sheets and high margins - Essential service and favorable demographic
Technology
- Strong balance sheets and FCF generation - Solid growth trends in software and cloud
$1500 $1000 $500 $0 LTM16
LTM17
1Q16
1Q17
U.S. IG Corporate Issuance U.S. Mergers & Acquisitions Source: Bloomberg, as of March 31, 2017.
t
t
Market Technical: Global Yields Nominal Yields Favor U.S. Corporate Bonds A sizable nominal yield pickup remains in U.S. IGt corporate relative to European and Japan IG corporates. While purchases are expected to be tapered, European central banks are still buying non-financial euro-denominated IG corporate bonds, actively removing supply and keeping allin yields low. Elevated USD hedging costs for foreigners are an offset to the sizable nominal yield differential, although foreign flows remain strong. Nominal Yield Divergence in Global IG Credit Nominal Yield Divergence in Global IG Credit 4.5% 4.0% 3.5%
Yield-to-Worst
3.0% 2.5% 2.0% 1.5% 1.0% 0.5%
t
7
6
1Q 1
6
3Q 1
5
1Q 1
5
3Q 1
4
1Q 1
4
3Q 1
3
1Q 1
3
3Q 1
2
1Q 1
2
3Q 1
1
1Q 1
3Q 1
1Q 1
1
0.0%
BAML U.S. Corporate Bond Index BAML Euro Corporate Index BAML Japan Corporate Index Source: BofA Merrill Lynch Corporate Indices, as of March 31, 2017.
Negative Outlook
Key Sector Drivers
Food/Beverage & Consumer Products
- Growing pressure from pricing bifurcation - Rise of digital marketing and e-commerce
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
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12-18 months. Source: Breckinridge Capital Advisors.
Breckinridge Strategy Looking Through the Noise We continue to see some positive catalysts in the IG corporate market primarily related to corporate profit growth, potential tax cuts, cash repatriation and deregulation, although we recognize uncertainties surrounding the Trump administration’s fiscal plans and headwinds to effective implementation. However, financial leverage and event risk is high and the possibility of tariffs, trade disputes and geopolitical flare-ups are risks to the market. Considering current valuations and our stated view on the credit cycle, we are continuing to target an overweight to higher-quality AA-rated and A-rated corporates and an underweight to lower-quality BBB corporates within our government credit strategies. In today’s noisy politicized landscape, we believe that management teams of larger, global corporations should focus on long-term strategy and not be swayed by the t
5
Q1 2017 CORPORATE BOND COMMENTARY winds of political change, which may be fickle and relatively short-lived. We continue to focus on investing in the bonds of high-quality companies that have meaningful leverage
and/or credit ratings targets, conservative financial philosophies, an established commitment to innovation and balanced ESG profiles.
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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