Q3 2016 CORPORATE BOND COMMENTARY
COMMENTARY
Q3 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Weakening credit fundamentals
due to high leverage and lackluster earnings growth.
• Central bank accommodation a benefit to corporate market performance.
• Ongoing solid demand from foreign investors seeking higher yields.
INVESTMENT OUTLOOK Follow the Leaders The credit cycle has been extended by central bank policies that enable high corporate borrowing at very low interest rates. As a result, median total debt-toEBITDA for U.S. investment-grade (IG) credits has moved just above three times, which is slightly higher than the peak in 2008 to 2009.1 High financial leverage combined with weak earnings growth and near-record share buybacks and dividends has conspired to weaken credit metrics and ratings agency outlooks.2 So, fundamentals are still in a declining credit phase. However, other key credit drivers, including central bank policy, strong fund and foreign flows and a global reach for yield, have provided a counterbalance and allowed for solid corporate market performance—even in the face of weak credit fundamentals. This delicate balance cannot last forever. The sharp balance-sheet focus that was so prevalent among IG companies during and immediately following the global financial crisis (GFC) and the Great Recession is a distant memory, except in the Banking, Energy and Mining sectors, where circumstances have forced managements to focus on credit. For the credit cycle to shift decidedly out of a multiyear declining phase may require a financial shock and economic contraction that would force companies to focus on shoring up finances. Figure 1: Declining Credit Phase
Declining Credit 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 Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
Unfortunately, with borrowing rates so low and corporate commercial paper (CP) usage contracting, IG companies have little incentive to maintain high credit ratings—unless they are clearly needed for counterparty or business reasons.3 Accordingly, we continue to focus on investing in the bonds of strongly 1
Q3 2016 CORPORATE BOND COMMENTARY capitalized banks, regulated utilities and industrial companies that have meaningful leverage or credit rating targets, conservative financial philosophies and leading business and ESG profiles.
CREDIT TRENDS DASHBOARD Upgrade Profits, Downgrade Leverage 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 two adjustments to our dashboard this quarter. Overall, we see frail fundamental credit conditions for IG corporate credit.
Credit Trends Dashboard Figure 2:Corporate Credit Trends Dashboard Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Fund Flows / Technicals Oil / Commodities Geopolitical Risk Event Risk Corporate Profits Industrials' Leverage Economy (Non-U.S.) Credit Rating Trends
Change Since Last Quarter
X X X X X X X X X X X X
While median cash-to-debt among U.S. IG-rated companies has steadily declined since 2013, it is still considered healthy relative to recent history. For instance, cash and short-term investments to total debt have averaged just above 8 percent since 2005, compared to a ratio of nearly 9 percent at the end of 2015.4 And, some large companies in the Technology and Pharmaceutical sectors run far higher cash balances. Excess cash and securities is a positive from a corporate bondholder perspective, particularly when a majority of that liquidity is readily available to fund capital spending and pay down debt and does not reside offshore, which would make it subject to punitive repatriation taxes. While we would like to see higher cash cushions in onshore bank accounts, we recognize that a tax holiday or a major shift in corporate tax policy following the U.S. presidential election could see some of the $2.5 trillion of U.S. company earnings held overseas returned to the U.S.5 Figure 3: U.S. Nonfinancial Cash-to-Debt is Still Healthy U.S. Nonfinancial Cash-to-Debt is Still Healthy
11% 10% 9% 8%
Summary Operating Trends Capital Sources Management / ESG Risks
STRENGTH: LIQUIDITY MEASURE REMAINS ABOVE AVERAGE A Counterbalance to High Debt
X X X
Source: Breckinridge.
Key credit drivers that changed during the quarter: • Corporate Profits: We upgraded our assessment of this driver from moderate weakness to modest weakness. After five quarters in a row of negative year-over-year (YoY) profit growth, S&P 500 earnings are currently forecast to decline by another 1.8 percent in 3Q16 YoY. However, consensus corporate profit growth is forecast to turn positive in the fourth quarter of 2016 for S&P 500 companies, as YoY comparables become easier. • Industrials Leverage: We downgraded our assessment of this driver from modest weakness to moderate weakness. Median total debt-to-EBITDA for U.S. IG companies has moved just above three times, per S&P, which is slightly higher than the peak in 2008 to 2009. Excessive debt relative to cash flow can negatively affect a company’s creditworthiness and drive ratings agency downgrades.
7% 6% 5% 4%
2005
2006 2007
2008
2009
2010
2011
2012
2013
2014
2015
U.S. IG Median Cash-to-Debt Average Source: Standard & Poor’s Financial Services LLC, as of September 30, 2016.
STRENGTH: CORPORATE PROFIT GROWTH SET TO RECOVER IN 2017 After Several Quarters of Negative Growth S&P 500 companies are poised to log their sixth quarter in a row of negative EPS growth YoY, representing a socalled “profits recession” not seen since the immediate aftermath of the 2008-2009 global financial crisis. Due to sustained low commodity prices, energy and mining companies have faced the steepest decline in profits over the past several quarters. U.S. multinationals with exposure to emerging markets and to a strong U.S. dollar have also faced persistent earnings headwinds. However, U.S. service-focused companies in consumerfacing industries generally have delivered solid results consistent with steady U.S. economic growth. 2
Q3 2016 CORPORATE BOND COMMENTARY WEAKNESS: LEVERAGE IS ABOVE FINANCIAL CRISIS LEVELS High Leverage is a Risk if the Economy Slows
Consensus Earnings Growth (YoY %)
Figure 4: S&P 500 Earnings S&P 500 Growth Earnings Growth 15%
Gross debt leverage for the IG- and high-yield (HY)-rated corporate cohorts has reached a record high. Median gross debt-to-EBITDA has moved beyond three times for U.S. IGrated companies, just above the 2008 to 2009 recessionary period. As mentioned, excessive debt relative to cash flow can lead to ratings downgrades.
10% 5% 0% -5% -10%
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16E 4Q16E 1Q17E 2Q17E 3Q17E
Source: Bloomberg, as of September 30, 2016.
WEAKNESS: DIVIDENDS RISING WHILE ROIC IS DECLINING Common stock dividends paid by S&P 500 companies have accelerated since 2013 to reach more than 50 percent of earnings at the end of the second quarter, up from a range of 35 to 40 percent from 2010 to 2013.6 In fact, including stock buybacks, which are another shareholder enhancement, payouts are running over 100 percent of earnings, which means that many companies are paying out all of their internally generated capital. Highly profitable and financially stable companies in mature businesses are capable of paying out a high percentage of their earnings. However, at the same time enhancements are near record levels, corporate profit margins and returns on capital have declined. Total debt has risen as shareholder enhancements have outpaced internally generated funds.
60% 55%
9%
50% 45%
8%
40% 7%
6%
35% 30% 2010
Profit Margin (lhs)
2011
2012
2013
2014
2015
2Q16
Return on Capital (lhs) Dividend Payout Ratio (rhs) Source: Bloomberg, as of September 30, 2016.
Figure 6: U.S. Nonfinancial Leverage is Above Levels DuringU.S. the Great Recession Nonfinancial Leverage is Above Great Recession 3.1x
5.5x
3.0x
5.0x
2.9x
4.5x
2.8x
4.0x
2.7x
3.5x
2.6x
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
3.0x
IG Median Debt-to-EBITDA (lhs) HY Median Debt-to-EBITDA (rhs) Source: Standard & Poor’s Financial Services, LLC, as of September 30, 2016.
Figure 5: Strong StrongDividend Dividend Growth Belies a Weaker Growth Belies a Weaker ROIC ROIC 10%
Financial leverage ratios are considered to be among the most important indicators of credit distress and default, which is why a sharp move in leverage above historical medians should be considered a material weakness. While IG leverage is clearly higher, leverage for HY companies is even more notable: median gross debt-to-EBITDA has moved toward 5.5 times for U.S. HY credits, which is now a full turn higher than the peak in 2008.7
RETURNS: SOLID CORPORATE MARKET PERFORMANCE Lower-Quality Bonds Outperformed in 3Q16 The total return for the intermediate IG corporate bond market was 0.93 percent in the third quarter, Barclays data showed. Compared to duration-neutral Treasuries, the intermediate IG corporate bond market generated 119 basis points (bps) of excess return in the third quarter.8 For the third quarter in a row, lower-quality BBB-rated corporate bonds outperformed the broader IG corporate market. In contrast, higher-quality AA-rated bonds underperformed the corporate market, as they have for three quarters in a row.9
3
Q3 2016 CORPORATE BOND COMMENTARY Figure 7: Returns by Rating
(OAS) of 112bps and are almost 30bps tighter on a yearto-date basis.11 Lower-quality BBB corporate spreads tightened 25bps on average during the quarter, compared to A and AA rated bonds, which tightened by 11bps and 3bps, respectively. The quality spread between AA and BBB corporate bonds ended the quarter at 91bps, its tightest level since March 2015.12
Returns by Rating
1.8% 1.6% 1.4% 1.2% 1.0% 0.8%
Figure 9: Corporate Quality Spread Comparison Corporate Quality Spreads
0.6% 0.4%
300
0.2%
250
AA Corp.
ENERGY AND BASICS LEAD RETURNS IN 3Q16
Figure 8: Returns by Sector Returns by Sector 2.5% 2.0%
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For the second quarter in a row, Energy sector bonds notably outperformed the IG corporate bond index. Specifically, Energy bonds had an excess return of 2.42 percent and outperformed the index, by 123bps in the third quarter. Oil prices saw some stability in the quarter, and energy companies have generally boosted liquidity in an effort to ride out the low oil-price period. The Basic Industries sector also outperformed the market during the third quarter, by 85bps, driven partly by Metals and Mining on iron ore firmness. Utility bonds underperformed by 46bps on relatively tight valuations.10
200
5
Total Return Excess Return Source: Barclays Intermediate Corporate Index, as of September 30, 2016.
-1
A Corp.
ay
IG Corporate
M
BBB Corp.
OAS (bps)
0.0%
AA A BBB Source: Barclays, as of September 30, 2016.
MARKET TECHNICAL: SUPPLY AND M&A Supply Was Up While Merger Activity Slowed U.S. IG corporate bond issuance of $369 billion in the third quarter was about 23 percent higher on a yearover-year basis.13 The financial sector accounted for 42 percent of issuance volume, based partly on future TLAC needs, refinancing needs and Yankee bank issuance.14 The Technology sector represented 11 percent of volume as the sector continues to fund a portion of its M&A, share buybacks and dividends with U.S. bond issuance. Overall, U.S. M&A volume of $574 billion declined about 24 percent YoY, reflecting a combination of elevated valuation multiples, increased antitrust scrutiny and ongoing global economic uncertainty.
1.5% 1.0% 0.5%
ry na nc R e Co EIT Br S ok m pa er s/ ni As es se tM g In su rs r Te anc Co e ch rp no or at logy Co e M m a m un rke t ic Tr an atio sp ns or Ot ta he tio rI n nd us Co tr ns ia um l Ba er nk N i Co n ns onc g um yc er lica l Cy Ca cl i pi ta cal lG oo ds Ut ili ty
st
du
Figure 10: Low Interest Rates are Fueling High Borrowing Low Interest Rates are Fueling High Borrowing and Merger Activities and Merger Activities 2000 1800
Fi
Ba
si c
In
En e
rg y
0.0%
SPREADS: STEADY NARROWING DURING 3Q16 BBB Corporates Tighten Twice as Much as Single-As Intermediate IG corporate bond spreads tightened 15bps in the third quarter at an average option-adjusted spread
1400 $ Billions
Total Return Excess Return Source: Barclays Intermediate Corporate Index, as of September 30, 2016.
1600 1200 1000 800 600 400 200 0 YTD15
YTD16
3Q15
3Q16
U.S. IG Corporate Bond Issuance U.S. Mergers & Acquisitions Source: Bloomberg, as of September 30, 2016.
4
Q3 2016 CORPORATE BOND COMMENTARY
U.S. dollar-denominated (USD) IG corporates exhibit a significant nominal yield pickup relative to euro-denominated corporates. The yield differential, which began to widen in late 2012, is still notable. U.S. intermediate corporates yielded 2.8 percent, while Europe yielded 0.7 percent and Japan yielded 0.2 percent at the end of the third quarter.15 Not coincidentally, foreign purchases of U.S. corporate bonds spiked in 2013 and have remained strong since then, as global investors look to take advantage of higher relative yields and liquidity in the U.S. IG corporate market. The ECB and the BoE are buying corporate bonds—including U.S. corporates, removing supply and driving yields lower. Furthermore, Brexit and anemic economic growth across the eurozone have driven bond yields lower and in some cases, into negative territory. The slowdown in economic growth in Europe also makes the U.S. corporate market an attractive alternative. However, USD hedging costs are rising and are an offset to the nominal yield differential. Figure 11: A Notable Yield Divergence in Global IG Credit A Notable Yield Divergence in Global IG Credit
5%
Yield-to-Worst (%)
4% 3%
Figure 12: High-Grade Fixed Income has Benefited from Steady Domestic Fund has Flows High-Grade Fixed Income Benefited from Steady Domestic Fund Flows 30000 U.S. Fund Flows ($ Millions)
MARKET TECHNICAL: A GLOBAL YIELD COMPARISON Nominal Yields Favor U.S.-Denominated Corporates
25000 20000 15000 10000 5000 0 Jan-16 Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16 Sep-16
Taxable Bond Mutual Funds + ETFs Source: ICI, as of September 30, 2016.
Another important trend is the net purchase of U.S. corporate bonds by foreign residents. Since 2013, foreign investors have purchased over $1 trillion of U.S. corporate bonds.17 In 2015, foreign residents purchased $361 billion of U.S. corporate bonds, or 22 percent of the $1.6 trillion of IG corporate and high-yield new-issue markets. And, over the first half of 2016, net purchases accelerated to about $500 billion (54 percent of U.S. IG and HY corporate bond primary market supply), creating a powerful technical and source of demand. Foreign flows were negative from 2010-2012 in U.S. corporate bonds, but picked sharply up in 2013 when yield differentials became more pronounced between the U.S. and Europe. Figure 13: Foreign Demand Remains an Important Driver in Foreign Demand Remains an Important Driver in the IG Corporate Market the IG Corporate Market
2% 1%
16 2Q
4Q 15
14
15 2Q
4Q
13
13
14 2Q
4Q
2Q
12 4Q
2Q 12
4Q 11
11 2Q
4Q 10
2Q 10
0%
U.S. Corporate Bond Index Euro Corporate Index Japan Corporate Index Source: The BofA Merrill Lynch Corporate Indices, as of September 30, 2016.
MARKET TECHNICAL: U.S. AND FOREIGN FLOWS Strong Flows into U.S. Corporates Taxable bond investment vehicles have experienced consistently strong inflows as investors have moved into bonds from equities due to global growth weakness and market uncertainties. Taxable bond mutual funds and exchange-traded funds reported net inflows of over $70 billion in the third quarter, and year-to-date flows have recently surpassed $130 billion.16
Foreign Flows ($ Billions)
600 500 400 300 200 100 0 2013
2014
2015
1H16
Net Purchases of U.S. Corporate Bonds by Foreign Residents Source: Federal Reserve Flow of Funds, as of September 30, 2016.
SUMMARY: SECTOR OUTLOOKS Divergence in Credit Fundamentals Our credit research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and environmental, social and governance (ESG) drivers are evaluated through rigorous analysis. Our corporate analysts’ sector outlooks and relative value assessments inform our Investment Committee, as it formulates strategy 5
Q3 2016 CORPORATE BOND COMMENTARY 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 13: Sector Outlooks Stable/Positive Outlook
Key Sector Drivers
Consumer Non-Cyclical
- Strong increase in pharmaceutical product pipeline - M&A cycle slowing as regulators block deals
Consumer Cyclical
- Continued strength in consumer spending - Solid U.S. housing market and auto sales
Communications
- Consolidation has created stronger players - Deleveraging efforts have followed M&A
Negative Outlook
Key Sector Drivers
Insurance
- Low rates impacting investment income - Activist pressure to split off segments
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
BRECKINRIDGE STRATEGY A Focus on Strength Corporate credit fundamentals are still in a declining credit phase. While central bank accommodation has propped up corporate market performance and served as a counterbalance to weak fundamentals, we think that this balance cannot last forever and credit selection is paramount. With the low-rate environment continuing, companies continue to be incentivized to borrow, and a major financial shock or economic contraction could be required to force companies to take on more conservative posturing. We continue to focus on high-quality credits that have meaningful leverage or credit rating targets, conservative financial philosophies and leading ESG profiles.
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12 to 18 months.
FOOTNOTES: 1. See S&P Global Ratings, “Financial Risk is Rising…”, August 9, 2016. 2. See S&P Ratings Services, “Corporate Ratings Trends…”, January 2016. 3. See Breckinridge, “New Money Market Rules…”, September 23, 2016. 4. See S&P Global Ratings, “Financial Risk is Rising…”, August 9, 2016. 5. The $2.5 trillion refers to cash and unrepatriated earnings of U.S. companies held overseas, per Capital Economics. SEC filings, Audit Analytics and Capital
Economics, September 20, 2016.
6. See Bloomberg screen, SPX Index , FA . 7. See S&P Global Ratings, “Financial Risk is Rising…”,
August 9, 2016.
8. Barclays, as of September 30, 2016. 9. Barclays, as of September 30, 2016. 10. Barclays, as of September 30, 2016. 11. Barclays U.S. Corporate Intermediate Investment
Grade Index, referring to Option Adjusted Spread, as of September 30, 2016. 12. Barclays, as of September 30, 2016. 13. Bloomberg, as of September 30, 2016.
14. The Financial Stability Board, in consultation with the
Basel Committee on Banking Supervision, proposed minimum standards for “total loss-absorbing capacity” (TLAC). The requirements are meant to improve the ability of banks to withstand financial stress and failure without imposing losses on taxpayers. 15. BofA Merrill Lynch Global Bond Indices, as of September 30, 2016. 16. ICI.org/research/stats. 17. Federal Reserve Flow of Funds.
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
Q3 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Weakening credit fundamentals
due to high leverage and lackluster earnings growth.
• Central bank accommodation a benefit to corporate market performance.
• Ongoing solid demand from foreign investors seeking higher yields.
INVESTMENT OUTLOOK Follow the Leaders The credit cycle has been extended by central bank policies that enable high corporate borrowing at very low interest rates. As a result, median total debt-toEBITDA for U.S. investment-grade (IG) credits has moved just above three times, which is slightly higher than the peak in 2008 to 2009.1 High financial leverage combined with weak earnings growth and near-record share buybacks and dividends has conspired to weaken credit metrics and ratings agency outlooks.2 So, fundamentals are still in a declining credit phase. However, other key credit drivers, including central bank policy, strong fund and foreign flows and a global reach for yield, have provided a counterbalance and allowed for solid corporate market performance—even in the face of weak credit fundamentals. This delicate balance cannot last forever. The sharp balance-sheet focus that was so prevalent among IG companies during and immediately following the global financial crisis (GFC) and the Great Recession is a distant memory, except in the Banking, Energy and Mining sectors, where circumstances have forced managements to focus on credit. For the credit cycle to shift decidedly out of a multiyear declining phase may require a financial shock and economic contraction that would force companies to focus on shoring up finances. Figure 1: Declining Credit Phase
Declining Credit 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 Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
Unfortunately, with borrowing rates so low and corporate commercial paper (CP) usage contracting, IG companies have little incentive to maintain high credit ratings—unless they are clearly needed for counterparty or business reasons.3 Accordingly, we continue to focus on investing in the bonds of strongly 1
Q3 2016 CORPORATE BOND COMMENTARY capitalized banks, regulated utilities and industrial companies that have meaningful leverage or credit rating targets, conservative financial philosophies and leading business and ESG profiles.
CREDIT TRENDS DASHBOARD Upgrade Profits, Downgrade Leverage 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 two adjustments to our dashboard this quarter. Overall, we see frail fundamental credit conditions for IG corporate credit.
Credit Trends Dashboard Figure 2:Corporate Credit Trends Dashboard Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Fund Flows / Technicals Oil / Commodities Geopolitical Risk Event Risk Corporate Profits Industrials' Leverage Economy (Non-U.S.) Credit Rating Trends
Change Since Last Quarter
X X X X X X X X X X X X
While median cash-to-debt among U.S. IG-rated companies has steadily declined since 2013, it is still considered healthy relative to recent history. For instance, cash and short-term investments to total debt have averaged just above 8 percent since 2005, compared to a ratio of nearly 9 percent at the end of 2015.4 And, some large companies in the Technology and Pharmaceutical sectors run far higher cash balances. Excess cash and securities is a positive from a corporate bondholder perspective, particularly when a majority of that liquidity is readily available to fund capital spending and pay down debt and does not reside offshore, which would make it subject to punitive repatriation taxes. While we would like to see higher cash cushions in onshore bank accounts, we recognize that a tax holiday or a major shift in corporate tax policy following the U.S. presidential election could see some of the $2.5 trillion of U.S. company earnings held overseas returned to the U.S.5 Figure 3: U.S. Nonfinancial Cash-to-Debt is Still Healthy U.S. Nonfinancial Cash-to-Debt is Still Healthy
11% 10% 9% 8%
Summary Operating Trends Capital Sources Management / ESG Risks
STRENGTH: LIQUIDITY MEASURE REMAINS ABOVE AVERAGE A Counterbalance to High Debt
X X X
Source: Breckinridge.
Key credit drivers that changed during the quarter: • Corporate Profits: We upgraded our assessment of this driver from moderate weakness to modest weakness. After five quarters in a row of negative year-over-year (YoY) profit growth, S&P 500 earnings are currently forecast to decline by another 1.8 percent in 3Q16 YoY. However, consensus corporate profit growth is forecast to turn positive in the fourth quarter of 2016 for S&P 500 companies, as YoY comparables become easier. • Industrials Leverage: We downgraded our assessment of this driver from modest weakness to moderate weakness. Median total debt-to-EBITDA for U.S. IG companies has moved just above three times, per S&P, which is slightly higher than the peak in 2008 to 2009. Excessive debt relative to cash flow can negatively affect a company’s creditworthiness and drive ratings agency downgrades.
7% 6% 5% 4%
2005
2006 2007
2008
2009
2010
2011
2012
2013
2014
2015
U.S. IG Median Cash-to-Debt Average Source: Standard & Poor’s Financial Services LLC, as of September 30, 2016.
STRENGTH: CORPORATE PROFIT GROWTH SET TO RECOVER IN 2017 After Several Quarters of Negative Growth S&P 500 companies are poised to log their sixth quarter in a row of negative EPS growth YoY, representing a socalled “profits recession” not seen since the immediate aftermath of the 2008-2009 global financial crisis. Due to sustained low commodity prices, energy and mining companies have faced the steepest decline in profits over the past several quarters. U.S. multinationals with exposure to emerging markets and to a strong U.S. dollar have also faced persistent earnings headwinds. However, U.S. service-focused companies in consumerfacing industries generally have delivered solid results consistent with steady U.S. economic growth. 2
Q3 2016 CORPORATE BOND COMMENTARY WEAKNESS: LEVERAGE IS ABOVE FINANCIAL CRISIS LEVELS High Leverage is a Risk if the Economy Slows
Consensus Earnings Growth (YoY %)
Figure 4: S&P 500 Earnings S&P 500 Growth Earnings Growth 15%
Gross debt leverage for the IG- and high-yield (HY)-rated corporate cohorts has reached a record high. Median gross debt-to-EBITDA has moved beyond three times for U.S. IGrated companies, just above the 2008 to 2009 recessionary period. As mentioned, excessive debt relative to cash flow can lead to ratings downgrades.
10% 5% 0% -5% -10%
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16E 4Q16E 1Q17E 2Q17E 3Q17E
Source: Bloomberg, as of September 30, 2016.
WEAKNESS: DIVIDENDS RISING WHILE ROIC IS DECLINING Common stock dividends paid by S&P 500 companies have accelerated since 2013 to reach more than 50 percent of earnings at the end of the second quarter, up from a range of 35 to 40 percent from 2010 to 2013.6 In fact, including stock buybacks, which are another shareholder enhancement, payouts are running over 100 percent of earnings, which means that many companies are paying out all of their internally generated capital. Highly profitable and financially stable companies in mature businesses are capable of paying out a high percentage of their earnings. However, at the same time enhancements are near record levels, corporate profit margins and returns on capital have declined. Total debt has risen as shareholder enhancements have outpaced internally generated funds.
60% 55%
9%
50% 45%
8%
40% 7%
6%
35% 30% 2010
Profit Margin (lhs)
2011
2012
2013
2014
2015
2Q16
Return on Capital (lhs) Dividend Payout Ratio (rhs) Source: Bloomberg, as of September 30, 2016.
Figure 6: U.S. Nonfinancial Leverage is Above Levels DuringU.S. the Great Recession Nonfinancial Leverage is Above Great Recession 3.1x
5.5x
3.0x
5.0x
2.9x
4.5x
2.8x
4.0x
2.7x
3.5x
2.6x
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
3.0x
IG Median Debt-to-EBITDA (lhs) HY Median Debt-to-EBITDA (rhs) Source: Standard & Poor’s Financial Services, LLC, as of September 30, 2016.
Figure 5: Strong StrongDividend Dividend Growth Belies a Weaker Growth Belies a Weaker ROIC ROIC 10%
Financial leverage ratios are considered to be among the most important indicators of credit distress and default, which is why a sharp move in leverage above historical medians should be considered a material weakness. While IG leverage is clearly higher, leverage for HY companies is even more notable: median gross debt-to-EBITDA has moved toward 5.5 times for U.S. HY credits, which is now a full turn higher than the peak in 2008.7
RETURNS: SOLID CORPORATE MARKET PERFORMANCE Lower-Quality Bonds Outperformed in 3Q16 The total return for the intermediate IG corporate bond market was 0.93 percent in the third quarter, Barclays data showed. Compared to duration-neutral Treasuries, the intermediate IG corporate bond market generated 119 basis points (bps) of excess return in the third quarter.8 For the third quarter in a row, lower-quality BBB-rated corporate bonds outperformed the broader IG corporate market. In contrast, higher-quality AA-rated bonds underperformed the corporate market, as they have for three quarters in a row.9
3
Q3 2016 CORPORATE BOND COMMENTARY Figure 7: Returns by Rating
(OAS) of 112bps and are almost 30bps tighter on a yearto-date basis.11 Lower-quality BBB corporate spreads tightened 25bps on average during the quarter, compared to A and AA rated bonds, which tightened by 11bps and 3bps, respectively. The quality spread between AA and BBB corporate bonds ended the quarter at 91bps, its tightest level since March 2015.12
Returns by Rating
1.8% 1.6% 1.4% 1.2% 1.0% 0.8%
Figure 9: Corporate Quality Spread Comparison Corporate Quality Spreads
0.6% 0.4%
300
0.2%
250
AA Corp.
ENERGY AND BASICS LEAD RETURNS IN 3Q16
Figure 8: Returns by Sector Returns by Sector 2.5% 2.0%
150 100
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For the second quarter in a row, Energy sector bonds notably outperformed the IG corporate bond index. Specifically, Energy bonds had an excess return of 2.42 percent and outperformed the index, by 123bps in the third quarter. Oil prices saw some stability in the quarter, and energy companies have generally boosted liquidity in an effort to ride out the low oil-price period. The Basic Industries sector also outperformed the market during the third quarter, by 85bps, driven partly by Metals and Mining on iron ore firmness. Utility bonds underperformed by 46bps on relatively tight valuations.10
200
5
Total Return Excess Return Source: Barclays Intermediate Corporate Index, as of September 30, 2016.
-1
A Corp.
ay
IG Corporate
M
BBB Corp.
OAS (bps)
0.0%
AA A BBB Source: Barclays, as of September 30, 2016.
MARKET TECHNICAL: SUPPLY AND M&A Supply Was Up While Merger Activity Slowed U.S. IG corporate bond issuance of $369 billion in the third quarter was about 23 percent higher on a yearover-year basis.13 The financial sector accounted for 42 percent of issuance volume, based partly on future TLAC needs, refinancing needs and Yankee bank issuance.14 The Technology sector represented 11 percent of volume as the sector continues to fund a portion of its M&A, share buybacks and dividends with U.S. bond issuance. Overall, U.S. M&A volume of $574 billion declined about 24 percent YoY, reflecting a combination of elevated valuation multiples, increased antitrust scrutiny and ongoing global economic uncertainty.
1.5% 1.0% 0.5%
ry na nc R e Co EIT Br S ok m pa er s/ ni As es se tM g In su rs r Te anc Co e ch rp no or at logy Co e M m a m un rke t ic Tr an atio sp ns or Ot ta he tio rI n nd us Co tr ns ia um l Ba er nk N i Co n ns onc g um yc er lica l Cy Ca cl i pi ta cal lG oo ds Ut ili ty
st
du
Figure 10: Low Interest Rates are Fueling High Borrowing Low Interest Rates are Fueling High Borrowing and Merger Activities and Merger Activities 2000 1800
Fi
Ba
si c
In
En e
rg y
0.0%
SPREADS: STEADY NARROWING DURING 3Q16 BBB Corporates Tighten Twice as Much as Single-As Intermediate IG corporate bond spreads tightened 15bps in the third quarter at an average option-adjusted spread
1400 $ Billions
Total Return Excess Return Source: Barclays Intermediate Corporate Index, as of September 30, 2016.
1600 1200 1000 800 600 400 200 0 YTD15
YTD16
3Q15
3Q16
U.S. IG Corporate Bond Issuance U.S. Mergers & Acquisitions Source: Bloomberg, as of September 30, 2016.
4
Q3 2016 CORPORATE BOND COMMENTARY
U.S. dollar-denominated (USD) IG corporates exhibit a significant nominal yield pickup relative to euro-denominated corporates. The yield differential, which began to widen in late 2012, is still notable. U.S. intermediate corporates yielded 2.8 percent, while Europe yielded 0.7 percent and Japan yielded 0.2 percent at the end of the third quarter.15 Not coincidentally, foreign purchases of U.S. corporate bonds spiked in 2013 and have remained strong since then, as global investors look to take advantage of higher relative yields and liquidity in the U.S. IG corporate market. The ECB and the BoE are buying corporate bonds—including U.S. corporates, removing supply and driving yields lower. Furthermore, Brexit and anemic economic growth across the eurozone have driven bond yields lower and in some cases, into negative territory. The slowdown in economic growth in Europe also makes the U.S. corporate market an attractive alternative. However, USD hedging costs are rising and are an offset to the nominal yield differential. Figure 11: A Notable Yield Divergence in Global IG Credit A Notable Yield Divergence in Global IG Credit
5%
Yield-to-Worst (%)
4% 3%
Figure 12: High-Grade Fixed Income has Benefited from Steady Domestic Fund has Flows High-Grade Fixed Income Benefited from Steady Domestic Fund Flows 30000 U.S. Fund Flows ($ Millions)
MARKET TECHNICAL: A GLOBAL YIELD COMPARISON Nominal Yields Favor U.S.-Denominated Corporates
25000 20000 15000 10000 5000 0 Jan-16 Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16 Sep-16
Taxable Bond Mutual Funds + ETFs Source: ICI, as of September 30, 2016.
Another important trend is the net purchase of U.S. corporate bonds by foreign residents. Since 2013, foreign investors have purchased over $1 trillion of U.S. corporate bonds.17 In 2015, foreign residents purchased $361 billion of U.S. corporate bonds, or 22 percent of the $1.6 trillion of IG corporate and high-yield new-issue markets. And, over the first half of 2016, net purchases accelerated to about $500 billion (54 percent of U.S. IG and HY corporate bond primary market supply), creating a powerful technical and source of demand. Foreign flows were negative from 2010-2012 in U.S. corporate bonds, but picked sharply up in 2013 when yield differentials became more pronounced between the U.S. and Europe. Figure 13: Foreign Demand Remains an Important Driver in Foreign Demand Remains an Important Driver in the IG Corporate Market the IG Corporate Market
2% 1%
16 2Q
4Q 15
14
15 2Q
4Q
13
13
14 2Q
4Q
2Q
12 4Q
2Q 12
4Q 11
11 2Q
4Q 10
2Q 10
0%
U.S. Corporate Bond Index Euro Corporate Index Japan Corporate Index Source: The BofA Merrill Lynch Corporate Indices, as of September 30, 2016.
MARKET TECHNICAL: U.S. AND FOREIGN FLOWS Strong Flows into U.S. Corporates Taxable bond investment vehicles have experienced consistently strong inflows as investors have moved into bonds from equities due to global growth weakness and market uncertainties. Taxable bond mutual funds and exchange-traded funds reported net inflows of over $70 billion in the third quarter, and year-to-date flows have recently surpassed $130 billion.16
Foreign Flows ($ Billions)
600 500 400 300 200 100 0 2013
2014
2015
1H16
Net Purchases of U.S. Corporate Bonds by Foreign Residents Source: Federal Reserve Flow of Funds, as of September 30, 2016.
SUMMARY: SECTOR OUTLOOKS Divergence in Credit Fundamentals Our credit research analysts conduct sector scans for investment opportunities. Issuer creditworthiness and environmental, social and governance (ESG) drivers are evaluated through rigorous analysis. Our corporate analysts’ sector outlooks and relative value assessments inform our Investment Committee, as it formulates strategy 5
Q3 2016 CORPORATE BOND COMMENTARY 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 13: Sector Outlooks Stable/Positive Outlook
Key Sector Drivers
Consumer Non-Cyclical
- Strong increase in pharmaceutical product pipeline - M&A cycle slowing as regulators block deals
Consumer Cyclical
- Continued strength in consumer spending - Solid U.S. housing market and auto sales
Communications
- Consolidation has created stronger players - Deleveraging efforts have followed M&A
Negative Outlook
Key Sector Drivers
Insurance
- Low rates impacting investment income - Activist pressure to split off segments
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
BRECKINRIDGE STRATEGY A Focus on Strength Corporate credit fundamentals are still in a declining credit phase. While central bank accommodation has propped up corporate market performance and served as a counterbalance to weak fundamentals, we think that this balance cannot last forever and credit selection is paramount. With the low-rate environment continuing, companies continue to be incentivized to borrow, and a major financial shock or economic contraction could be required to force companies to take on more conservative posturing. We continue to focus on high-quality credits that have meaningful leverage or credit rating targets, conservative financial philosophies and leading ESG profiles.
Note: Outlook represents Breckinridge expectations for the trajectory of sector credit and ESG fundamentals over the next 12 to 18 months.
FOOTNOTES: 1. See S&P Global Ratings, “Financial Risk is Rising…”, August 9, 2016. 2. See S&P Ratings Services, “Corporate Ratings Trends…”, January 2016. 3. See Breckinridge, “New Money Market Rules…”, September 23, 2016. 4. See S&P Global Ratings, “Financial Risk is Rising…”, August 9, 2016. 5. The $2.5 trillion refers to cash and unrepatriated earnings of U.S. companies held overseas, per Capital Economics. SEC filings, Audit Analytics and Capital
Economics, September 20, 2016.
6. See Bloomberg screen, SPX Index , FA . 7. See S&P Global Ratings, “Financial Risk is Rising…”,
August 9, 2016.
8. Barclays, as of September 30, 2016. 9. Barclays, as of September 30, 2016. 10. Barclays, as of September 30, 2016. 11. Barclays U.S. Corporate Intermediate Investment
Grade Index, referring to Option Adjusted Spread, as of September 30, 2016. 12. Barclays, as of September 30, 2016. 13. Bloomberg, as of September 30, 2016.
14. The Financial Stability Board, in consultation with the
Basel Committee on Banking Supervision, proposed minimum standards for “total loss-absorbing capacity” (TLAC). The requirements are meant to improve the ability of banks to withstand financial stress and failure without imposing losses on taxpayers. 15. BofA Merrill Lynch Global Bond Indices, as of September 30, 2016. 16. ICI.org/research/stats. 17. Federal Reserve Flow of Funds.
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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