Q4 2016 CORPORATE BOND COMMENTARY
COMMENTARY
Q4 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Corporate debt leverage is high,
but potential tax reform and cash repatriation may slow debt growth.
• Profits are expected to grow in 2017, but the strong U.S. dollar and tariffs are risks to multi-nationals.
• Foreign investors seeking higher
yields have ongoing solid demand for U.S. corporate bonds.
INVESTMENT OUTLOOK Unusual Uncertainty The future is unknown and there is uncertainty as to what events may ultimately transpire and influence the investment outlook. For the first time in eight years, the U.S. has a new president, administration and policy platform, and the investment outlook for the investment grade (IG) corporate bond market for 2017 is unusually uncertain. We see positive catalysts in the IG bond market primarily related to potential corporate tax cuts, cash repatriation and deregulation. The possibility of tariffs, trade disputes and geopolitical risks are negative outcomes, particularly for large U.S. exporters. Investment outcomes will be impacted by the ultimate combination of government policy, economic indicators, fundamental credit trends and global fund flows. With that said, we turn back to our credit cycle framework and credit trends dashboard, our favored tools for assessing trends in corporate credit. In recent years, large IG corporates have re-leveraged their balance sheets beyond even the heady U.S. housing boom era roughly ten years ago. High debt incurrence has been tacitly encouraged by overly accommodative central bank policies, which have maintained interest rates at exceptionally low levels for several years. Additionally, a global savings glut and persistent demand for yield has kept IG corporate spreads relatively tight, despite weak credit fundamentals. At the same time, with the Federal Reserve tightening monetary policy and three Fed rate hikes expected in 2017, loose monetary policy is no longer a tailwind for corporate credit. U.S. government fiscal policy may be poised to replace monetary policy as a tailwind if corporate-friendly policies are implemented. But, this is uncertain, and some policies could be credit negative for specific sectors. In today’s environment, we continue to focus on long-term investing with an emphasis on high-quality companies with an eye toward reinvesting into their businesses for the long term.
1
Q4 2016 CORPORATE BOND COMMENTARY Declining Credit Phase Declining Credit Phase
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
• Corporate Profits: We upgraded our assessment of this driver from modest weakness to neutral. S&P 500 earnings beat forecasts in 3Q16, growing 2.9 percent year-over-year. Solid profit growth is forecast in 2017 because of potential tax reform, easier comparables and a resurgent financials sector. A strong U.S. dollar and potential tariffs in certain sectors are key risks for large exporters.
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
• Oil /Commodities: We upgraded our assessment of this driver from modest weakness to neutral. Oil prices have responded positively to announced OPEC production cuts, among other factors. A steady recovery in key commodity prices (e.g. oil, natural gas, steel and iron ore) has stabilized energy and basic industry credits.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
CREDIT TRENDS DASHBOARD Upgrade Operating Trends, Downgrade Central Bank Accommodation 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 four adjustments to our dashboard thisDashboard quarter. Corporate Credit Trends Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Fund Flows / Technicals Corporate Profits Oil / Commodities Geopolitical Risk Event Risk 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
Summary Operating Trends Capital Sources Management / ESG Risks
X X X
Source: Breckinridge.
Key credit drivers that changed during the quarter: • Central Bank Accommodation: We downgraded our assessment of this driver from moderate strength to neutral. We expect three Fed rate hikes in 2017 and a moderate pace of policy tightening. Fed policy is no longer a tailwind for corporate credit. However, the ECB, the BoE and the BoJ remain accommodative.
• Operating Trends: We upgraded our assessment of this driver from modest weakness to neutral due partly to the S&P 500 Index earnings beat in the third quarter. After a so-called profits recession over the past several quarters, S&P 500 companies should deliver improved results in 2017, as mentioned. Earnings-per-share are forecast to grow double-digits in 2017, while sales are predicted to be weaker—a multi-year dynamic. On the flip side, the strong U.S. dollar is a key risk for U.S. exporters.
STRENGTH: HIGHER RATES INCREASE BANK INTEREST INCOME Rising Margins and Profitability A bank’s net interest income (i.e. interest income minus interest expense) is sensitive to shifts in interest rates. The level of sensitivity is based on the mix and duration of that institution’s income-generating assets and interest expense-generating liabilities. It is also based on the overall proportion of fixed-rate to floating-rate instruments employed. Overall, the multi-year decline in U.S. interest rates negatively impacted U.S. banks’ net interest income and net interest margin metrics. As interest rates move higher, U.S. banks stand to benefit, as income from lending activities typically rises faster than the cost of funding (e.g., core deposits). Net interest income could rise over $10 billion for the largest four U.S. banks if rates rise by 1 percent, per recent SEC 10-Q filings. This estimated figure assumes a +100 bps parallel shift in the yield curve (which may or may not happen). Per Bloomberg, the consensus yield forecast presently calls for 125 bps and 100 bps increases in the 2-year and 10year U.S. Treasury yields over the next 18 months in a moderate bear flattening move.
2
Q4 2016 CORPORATE BOND COMMENTARY
6 5
$ Billions
4 3 2 1 0 Bank of America
JPMorgan
Wells Fargo
Citigroup
Estimated Increase in Net Interest Income if Interest Rates Increase by 1%* *Assumes a +100 bps parallel shift in the yield curve Source: SEC 10-Q Filings, as of 3Q16.
STRENGTH: PROFIT GROWTH TO RECOVER IN 1H17 Profits Recession Appears to be Over As discussed, S&P 500 companies appear to be positioned to report improved profit growth in 1H 2017 and S&P 500 companies’ after-tax earnings turned positive in the third quarter. The potential cut in U.S. corporate tax rates from 35 percent to the 8-15 percent range, and easier YoY profit comparisons in 1H2017 versus 1H2016, are both potential boosts to 2017 profit growth. Of course, the consensus forecast for aggregate corporate profit growth is an educated guess, and may be derailed by a stronger than expected U.S. dollar; a more aggressive Fed tightening cycle; material policy shifts by the new U.S. incoming administration; or other factors. While we also expect some corporate profit growth in 2017, we are not as optimistic as the consensus. We expect modest growth as corporate profits transition from a headwind on our Credit Trends Dashboard into more of a neutral or modest tailwind. S&P 500 Index Earnings Growth (YoY%) S&P 500 Index Earnings Growth (YoY%) 15 12
Percent (%)
9 6 3 0 -3 -6 -9 2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16E 1Q17E 2Q17E 3Q17E 4Q17E
Estimated Increase in Net Interest Income if Interest Rates Increase by 1%* Source: Bloomberg, as of December 30, 2016.
WEAKNESS: UNDER-INVESTING, OVER-ENHANCING Taking a Backseat to Buybacks Buybacks and dividends for S&P 500 companies grew from $516 billion in 2010 to about $1 trillion in 2016, per FactSet Research. By contrast, capital expenditures for the same companies grew by about 50 percent over the same period. High borrowing to fund shareholder rewards or to back other spending has sharply increased debt, and this has been accompanied by little additional cash generation to service these medium-to-longer term liabilities. Certain Republican proposals to reduce or eliminate the tax deductibility of interest expense and to provide tax incentives for capital investment could—if made into laws—curb debt growth in favor of capital spending. In general, slowing debt growth and liquidity-draining shareholder enhancements and increasing investments in cash-generating plant, property and equipment would be considered a longer-term positive for IG corporate bondholders. Growth in Shareholder Rewards Outpaces Capex
Growth in Shareholder Rewards Outpaces Capex 200
150 Growth (%)
U.S. Banks’to Sensitivity to RisingRates Interest Rates U.S. Banks’ Sensitivity Rising Interest
100
50
0 S&P 500 Index Ex Financials*
Buybacks Dividends Cap Ex * Growth shown is the percent change between 12 months ending 9/30/2010 and 12 months ending 9/30/2016. Data is for the S&P 500 ex. Financials. Source: Computstat, Goldman Sachs, FactSet, as of 3Q16
WEAKNESS: GROSS DEBT NEARING HALF OF CAPITAL High Leverage Reduces Financial Flexibility On a book value basis, total debt has increased to nearly 50 percent of capital for S&P 500 non-financial companies—up from 40 percent just five years ago. While debt leverage is certainly lower when using the market value of equity as the denominator, book leverage remains an important indicator to rating agencies, commercial banks and bondholders alike. Furthermore, median debt to EBITDA has moved beyond 3 times for U.S. IG credits to levels just above the 2008-2009 peaks. Corporate management teams have a high relative cost differential and a significant tax incentive to utilize debt 3
Q4 2016 CORPORATE BOND COMMENTARY over equity. However, if the tax deductibility of interest expense is eliminated as proposed, then bond issuance may decline over time; this decline could occur particularly if interest rates continue to rise, which may slow the excess accumulation of debt. Cash repatriation by multi-nationals with large overseas cash hoards could also slow debt incurrence, as liquidity is tapped. S&P 500 Non-Financial Book Leverage S&P 500 Non-Financial CompanyCompany Book Leverage 50
Percent (%)
40 30
Energy and Finance Led Returns in 4Q16 For the third quarter in a row, Energy sector bonds outperformed the IG corporate bond index. Specifically, energy bonds had an excess return of 1.75 percent and outperformed the index by 106bps in the fourth quarter. Energy bond issuers benefited from sustained oil price stability in the fourth quarter brought on by announced OPEC production cuts and other factors. Financial bonds (e.g. finance, REITs, insurance and banking) outperformed due to the move higher in interest rates in 4Q16, which is expected to benefit net interest income if sustained. The Communications sector underperformed the corporate market by 73bps in 4Q16 on M&A activity and expected bond supply.
20
Returns by Sector Returns by Sector – 4Q16
10
2.0 1.5
0 2012
2013
2014
2015
Total Debt / Total Capital Source: Bloomberg, Standard & Poor’s Financial Services, LLC, as of December 2016.
RETURNS: SOLID CORPORATE MARKET EXCESS RETURNS Lower-Quality Bonds Outperformed in 4Q16 Based on a 75-85bps backup in benchmark 5-year and 7-year U.S. Treasury yields, respectively, the total return for the intermediate IG corporate market was negative 1.95 percent in the fourth 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 69bps of excess return in the fourth quarter. For the fourth quarter and the full year, lower-quality BBB-rated corporate bonds outperformed the broader IG corporate market. In contrast, higher-quality AA-rated bonds underperformed the corporate market for the same periods. Returns by Rating – 4Q16 Returns by Rating
0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0
Total Return Excess Return Source: Barclays Intermediate IG Corporate Index, as of December 30, 2016.
SPREADS: STEADY NARROWING IN 4Q16 AND FY16 BBB Corporates’ Outperformance Persisted Intermediate IG corporate bond spreads tightened by 8bps in the fourth quarter to an average option-adjusted spread (OAS) of 104bps—the tightest levels since May 2015. For the full-year 2016, corporate spreads were an impressive 35bps tighter. Lower-quality BBB corporate spreads tightened 21bps on average during the quarter, compared to AA-rated and A-rated bonds, which tightened by 8bps and 12bps, respectively. For 2016, BBB spreads tightened by a notable 78bps. The quality spread between AA-rated and BBB-rated corporate bonds ended the quarter and the year at 80bps— the tightest level since October 2014.
1.0 0.5 0.0 Percent (%)
1.0
2016
En er gy Co m pa ni Br es ok er RE s/ IT As se S tM gr s In su ra nc Ba e n Te kin g ch Co no rp lo or gy at e M Ba a sic rke t I n Ot du he st ry Co r In d ns um ustr ia er l Cy cli ca l Tr an Uti sp lity or ta Co Ca tio ns p n um ita er l Go No o nc ds Co yc m l m un ical ica tio ns
2011
ce
2010
an
2009
Fin
2008
Percent (%)
2007
-0.5 -1.0 -1.5 -2.0 -2.5 -3.0 BBB Corp.
IG Corporate
A Corp.
AA Corp.
Total Return Excess Return Source: Barclays Intermediate IG Corporate Index, as of December 30, 2016.
At current valuations, IG corporate spreads are slightly tighter than the long-term median (120bps) excluding periods of U.S. economic recession. Spreads are close to their post-financial crisis tights, but demand remains strong and we expect spreads to be rangebound in 2017.
4
Q4 2016 CORPORATE BOND COMMENTARY Corporate Quality Spreads
MARKET TECHNICAL: A GLOBAL YIELD COMPARISON Nominal Yields Favor U.S.-Denominated Corporates
Low Rates Have Have Driven HighHigh Borrowing but M&A Low Rates Driven Borrowing but M&AHas Has Slowed Slowed 3000 2500
$ Billions
2000 1500 1000 500 0 FY15
FY16
4Q15
4Q16
U.S. IG Corporate Bond Issuance U.S. Mergers & Acquisitions Bloomberg, as of December 30, 2016.
5% 4% 3% 2% 1%
16 4Q
16 2Q
15
15 4Q
2Q
14
14 4Q
2Q
13 4Q
2Q
13
0% 12
For 2016, robust IG corporate bond issuance of $1.35 trillion was slightly above 2015, as low interest rates continued to encourage record-level borrowing. U.S. M&A volume of $701 billion in 4Q16 declined about 22 percent year-over-year, reflecting a combination of elevated valuation multiples, increased antitrust scrutiny and global economic uncertainty. For FY16, M&A declined 18 percent to $2.3 trillion.
A Notable Yield Divergence in Global IG Credit
A Notable Yield Divergence in Global IG Credit
12
U.S. IG corporate bond issuance of $230 billion in the fourth quarter was about 15 percent lower on a year-over-year basis. The sharp move higher in interest rates and elevated volatility during the fourth quarter contributed to a slightly less favorable market for primary corporate bond issuance. The Financial sector accounted for 45 percent of issuance volume, based partly on future TLAC needs, refinancing needs and Yankee bank issuance. The Consumer Staples and discretionary sectors accounted for 15 percent and 9 percent, respectively, driven by M&A related bond issuance.
4Q
MARKET TECHNICAL: SUPPLY AND M&A Supply Was Up While Merger Activity Slowed
2Q
AA A BBB Source: Barclays Intermediate Corporate Index, as of December 30, 2016.
11
6
6
De c-1
6
No v1
6
t-1 Oc
6
6
16
Se p1
gAu
-1 Ju l
6 -1
6
Ju n1
ay M
6
6
-1
Ap r-1
ar M
6
Fe b1
Ja n1
De c-1
5
50
11
100
4Q
150
U.S. dollar-denominated IG corporates exhibit a significant nominal yield pickup relative to eurodenominated corporates. The yield differential, which began to widen in late 2012, is still notable. U.S. intermediate corporates yielded 3.5 percent, while Europe yielded 0.8 percent and Japan yielded 0.2 percent at the end of the fourth quarter. Not coincidentally, foreign purchases of U.S. corporate bonds spiked in 2013 and have remained strong since then, as global investors looked 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. The slowdown in economic growth in Europe also makes the U.S. corporate market an attractive alternative. However, U.S. dollar hedging costs are rising and offsetting the nominal yield differential.
2Q
200
10
OAS (bps)
250
4Q
300
Yield-to-Worst (%)
Corporate Spreads
U.S. Corporate Bond Index Euro Corporate Index Japan Corporate Index Source: The BofA Merrill Lynch Corporate Indices, as of December 30, 2016.
MARKET TECHNICAL: U.S. AND FOREIGN FLOWS Solid Flows into Taxable and IG Funds in 4Q16 Taxable bond and exchange-traded bond funds reported net inflows of $23 billion in 4Q16. Inflows slowed in the fourth quarter, as interest rates and equity markets have moved higher. For 2016, taxable bond funds reported net inflows of $162 billion, including $84 billion going into the IG category. It remains to be seen whether or not fund flows, an important source of demand for taxable bonds, can remain healthy given the Fed is expected to further lift short-term interest rates in 2017.
5
Q4 2016 CORPORATE BOND COMMENTARY
4.0
30000
3.5
25000
3.0
20000
2.5
15000 10000
1.5
0.5
0
0.0
Taxable Bond Mutual Funds + ETFs Investment Grade Bond Funds Source: ICI, as of December 30, 2016.
Strong Flows into Corporates from Foreign Investors Another important trend in gauging demand is the net purchase of U.S. corporate and foreign bonds by foreign residents. In fact, purchases of U.S. corporate bonds by foreign residents have been quite strong over the last few years. In 3Q16, foreigners bought almost $400 billion of U.S. corporate and foreign bonds at a seasonally adjusted annual rate, per Fed data. Elevated U.S. currency hedging costs for foreign investors is an offset that may slow these flows at some point. Foreign Demand Is a Key Theme and Positive Technical for Foreign Demand Is a Key Theme and Positive Technical the U.S. Corporatefor Bond Market the U.S. Corporate Bond Market 400
300
200
100
0 2013
2014
2015
U.S. Insurers
De c16
No v16
O ct -1 6
Se p16
Au g16
Ju l-1 6
Ju n16
M ay -1 6
Ap r-1 6
M ar -1 6
U.S. Banks
Fe b16
Ja n16
2.0
1.0
5000
-5000
Foreign Flows ($ Billions)
and Banks are Large Holders of Bonds Insurers and Insurers Banks are Large Holders of Bonds
($ Trillions)
U.S. Fund Flows ($ Millions)
High-Grade Fixed Income FlowsFlows Slowed Slightly in in 4Q16 High-Grade Fixed Income Slowed Slightly 4Q16 But Remained Robust FY16 Robust for FY16 Butfor Remained
U.S. Insurance and Banking Invested Bonds Source: FDIC, NAIC, as of December 2016.
SPECIAL INSIGHT: TAX REFORM: IMPACT ON CORPORATES Impacts Vary Based on Sector President-elect Trump’s victory has potential credit implications for a number of corporate sectors. The impact of Trump’s win will depend on the likelihood of real Federal policy shifts and changing regulations and laws. We think implications may initially be positive for financial companies, but more mixed for industrials, depending on the sector. Below, we outline the impact of certain tax reform measures on various parts of the corporate market. • Multinational companies: Trump has proposed cutting corporate tax rates, eliminating the tax deductibility of interest and implementing a one-time tax holiday to repatriate overseas corporate earnings and cash. These measures would be positive for after-tax earnings and could increase the cash coffers of corporations that repatriate overseas monies, thus slowing debt issuance over time. Much of the impact on multinationals depends on how liquidity is utilized (e.g., capital expenditures, share buybacks, dividends, debt reduction, or other usage).
3Q16 SAAR
Net Purchases of U.S. Corporate Bonds by Foreign Residents Source: Federal Reserve Flow of Funds, SAAR, as of 3Q16.
Insurers and Banks have a Large Appetite for Credit U.S. insurance companies and FDIC-insured commercial banks hold approximately $6.4 trillion of bonds between them. This ownership provides a steady source of demand for bonds through reinvestment of coupon income and funds from debt maturities. Assuming an average coupon of three percent, and three percent of bonds maturing each year, almost $400 billion is available for re-investment annually—creating a potent source of steady demand for IG corporate bonds.
• Banks/Insurers: Trump and certain Republicans have proposed repealing the 2010 Dodd-Frank Act. This could cause regulatory oversight, compliance and risk management costs to decline for banks and insurers. While this could support earnings near-term, longterm, this could create more credit risk by allowing banks and insurers to take greater risks and have thinner capital cushions. • Exporters/Importers: Trump has indicated a desire to renegotiate trade agreements and potentially levy tariffs or institute border taxes. A tariff could prompt the U.S. dollar to rise, negatively impacting U.S. exporters. A border-adjusted tax could also negatively impact Retail 6
Q4 2016 CORPORATE BOND COMMENTARY or Auto sectors where goods are imported to be sold in the U.S. However, the new trade protections could positively impact U.S. manufacturers using American parts and labor (such as Steel and Mining). • Construction/Defense: On the Construction side, Trump has discussed increasing infrastructure investment, which could be positive for construction machinery firms. On the Defense side, Trump has called for eliminating the defense sequester, which may be positive for some Defense companies; however, recent comments indicate some concern over high-cost military programs. • Pharmaceutical: The new administration could repeal the Affordable Care Act. This could impact some Pharmaceutical credits, as more than 20 million Americans could lose healthcare. We do expect a more favorable regulatory environment for businesses, but rhetoric suggests less patience for extraordinarily high drug prices. • Energy: Large energy firms could benefit from a new energy plan from Trump that would roll back subsidies on renewable energy projects and allow for greater investment in pipelines and fossil fuels. Additionally, potentially less stringent environmental regulations could allow for expanded drilling opportunities.
Overall, we think that the companies we invest in are highly creditworthy and remain well positioned to weather changing U.S. and global political landscapes.
BRECKINRIDGE STRATEGY Look to the Long Term While corporate debt leverage is very high, potential policy and regulatory adjustments could ease tax rates, and the U.S. administration’s proposed fiscal stimulus measures might extend the economic cycle by a year or two, and therefore we don’t expect a recession over the next 12-18 months. As mentioned, loose monetary policy is no longer a tailwind for corporate credit, but U.S. government fiscal policy could replace monetary policy as a tailwind for credit if corporatefriendly policies are implemented. But this is uncertain, and indeed some possible future trade policies (e.g. tariffs) could be credit negative to U.S. multi-nationals in certain sectors. In today’s uncertain environment, we believe that management teams of larger, global corporations should focus on long-term strategy and not be swayed by the 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 favorable 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.
7
Q4 2016 CORPORATE BOND COMMENTARY KEY TAKEAWAYS • Corporate debt leverage is high,
but potential tax reform and cash repatriation may slow debt growth.
• Profits are expected to grow in 2017, but the strong U.S. dollar and tariffs are risks to multi-nationals.
• Foreign investors seeking higher
yields have ongoing solid demand for U.S. corporate bonds.
INVESTMENT OUTLOOK Unusual Uncertainty The future is unknown and there is uncertainty as to what events may ultimately transpire and influence the investment outlook. For the first time in eight years, the U.S. has a new president, administration and policy platform, and the investment outlook for the investment grade (IG) corporate bond market for 2017 is unusually uncertain. We see positive catalysts in the IG bond market primarily related to potential corporate tax cuts, cash repatriation and deregulation. The possibility of tariffs, trade disputes and geopolitical risks are negative outcomes, particularly for large U.S. exporters. Investment outcomes will be impacted by the ultimate combination of government policy, economic indicators, fundamental credit trends and global fund flows. With that said, we turn back to our credit cycle framework and credit trends dashboard, our favored tools for assessing trends in corporate credit. In recent years, large IG corporates have re-leveraged their balance sheets beyond even the heady U.S. housing boom era roughly ten years ago. High debt incurrence has been tacitly encouraged by overly accommodative central bank policies, which have maintained interest rates at exceptionally low levels for several years. Additionally, a global savings glut and persistent demand for yield has kept IG corporate spreads relatively tight, despite weak credit fundamentals. At the same time, with the Federal Reserve tightening monetary policy and three Fed rate hikes expected in 2017, loose monetary policy is no longer a tailwind for corporate credit. U.S. government fiscal policy may be poised to replace monetary policy as a tailwind if corporate-friendly policies are implemented. But, this is uncertain, and some policies could be credit negative for specific sectors. In today’s environment, we continue to focus on long-term investing with an emphasis on high-quality companies with an eye toward reinvesting into their businesses for the long term.
1
Q4 2016 CORPORATE BOND COMMENTARY Declining Credit Phase Declining Credit Phase
Declining Debt rises Profits slow Rating downgrades Spreads widen Shareholders’ benefit
• Corporate Profits: We upgraded our assessment of this driver from modest weakness to neutral. S&P 500 earnings beat forecasts in 3Q16, growing 2.9 percent year-over-year. Solid profit growth is forecast in 2017 because of potential tax reform, easier comparables and a resurgent financials sector. A strong U.S. dollar and potential tariffs in certain sectors are key risks for large exporters.
Improving Debt declines Deleveraging Balance sheet focus Spreads tighten Bondholders’ benefit
• Oil /Commodities: We upgraded our assessment of this driver from modest weakness to neutral. Oil prices have responded positively to announced OPEC production cuts, among other factors. A steady recovery in key commodity prices (e.g. oil, natural gas, steel and iron ore) has stabilized energy and basic industry credits.
Stable Debt stabilizes Profits rise Rating upgrades Spreads tighten Shareholders’ / Bondholders’ benefit
Source: Breckinridge Capital Advisors, Wells Fargo, BCA.
CREDIT TRENDS DASHBOARD Upgrade Operating Trends, Downgrade Central Bank Accommodation 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 four adjustments to our dashboard thisDashboard quarter. Corporate Credit Trends Weakness Strength
Economy (U.S.) Financials' Leverage Central Bank Accommodation Regulatory Action Fund Flows / Technicals Corporate Profits Oil / Commodities Geopolitical Risk Event Risk 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
Summary Operating Trends Capital Sources Management / ESG Risks
X X X
Source: Breckinridge.
Key credit drivers that changed during the quarter: • Central Bank Accommodation: We downgraded our assessment of this driver from moderate strength to neutral. We expect three Fed rate hikes in 2017 and a moderate pace of policy tightening. Fed policy is no longer a tailwind for corporate credit. However, the ECB, the BoE and the BoJ remain accommodative.
• Operating Trends: We upgraded our assessment of this driver from modest weakness to neutral due partly to the S&P 500 Index earnings beat in the third quarter. After a so-called profits recession over the past several quarters, S&P 500 companies should deliver improved results in 2017, as mentioned. Earnings-per-share are forecast to grow double-digits in 2017, while sales are predicted to be weaker—a multi-year dynamic. On the flip side, the strong U.S. dollar is a key risk for U.S. exporters.
STRENGTH: HIGHER RATES INCREASE BANK INTEREST INCOME Rising Margins and Profitability A bank’s net interest income (i.e. interest income minus interest expense) is sensitive to shifts in interest rates. The level of sensitivity is based on the mix and duration of that institution’s income-generating assets and interest expense-generating liabilities. It is also based on the overall proportion of fixed-rate to floating-rate instruments employed. Overall, the multi-year decline in U.S. interest rates negatively impacted U.S. banks’ net interest income and net interest margin metrics. As interest rates move higher, U.S. banks stand to benefit, as income from lending activities typically rises faster than the cost of funding (e.g., core deposits). Net interest income could rise over $10 billion for the largest four U.S. banks if rates rise by 1 percent, per recent SEC 10-Q filings. This estimated figure assumes a +100 bps parallel shift in the yield curve (which may or may not happen). Per Bloomberg, the consensus yield forecast presently calls for 125 bps and 100 bps increases in the 2-year and 10year U.S. Treasury yields over the next 18 months in a moderate bear flattening move.
2
Q4 2016 CORPORATE BOND COMMENTARY
6 5
$ Billions
4 3 2 1 0 Bank of America
JPMorgan
Wells Fargo
Citigroup
Estimated Increase in Net Interest Income if Interest Rates Increase by 1%* *Assumes a +100 bps parallel shift in the yield curve Source: SEC 10-Q Filings, as of 3Q16.
STRENGTH: PROFIT GROWTH TO RECOVER IN 1H17 Profits Recession Appears to be Over As discussed, S&P 500 companies appear to be positioned to report improved profit growth in 1H 2017 and S&P 500 companies’ after-tax earnings turned positive in the third quarter. The potential cut in U.S. corporate tax rates from 35 percent to the 8-15 percent range, and easier YoY profit comparisons in 1H2017 versus 1H2016, are both potential boosts to 2017 profit growth. Of course, the consensus forecast for aggregate corporate profit growth is an educated guess, and may be derailed by a stronger than expected U.S. dollar; a more aggressive Fed tightening cycle; material policy shifts by the new U.S. incoming administration; or other factors. While we also expect some corporate profit growth in 2017, we are not as optimistic as the consensus. We expect modest growth as corporate profits transition from a headwind on our Credit Trends Dashboard into more of a neutral or modest tailwind. S&P 500 Index Earnings Growth (YoY%) S&P 500 Index Earnings Growth (YoY%) 15 12
Percent (%)
9 6 3 0 -3 -6 -9 2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16E 1Q17E 2Q17E 3Q17E 4Q17E
Estimated Increase in Net Interest Income if Interest Rates Increase by 1%* Source: Bloomberg, as of December 30, 2016.
WEAKNESS: UNDER-INVESTING, OVER-ENHANCING Taking a Backseat to Buybacks Buybacks and dividends for S&P 500 companies grew from $516 billion in 2010 to about $1 trillion in 2016, per FactSet Research. By contrast, capital expenditures for the same companies grew by about 50 percent over the same period. High borrowing to fund shareholder rewards or to back other spending has sharply increased debt, and this has been accompanied by little additional cash generation to service these medium-to-longer term liabilities. Certain Republican proposals to reduce or eliminate the tax deductibility of interest expense and to provide tax incentives for capital investment could—if made into laws—curb debt growth in favor of capital spending. In general, slowing debt growth and liquidity-draining shareholder enhancements and increasing investments in cash-generating plant, property and equipment would be considered a longer-term positive for IG corporate bondholders. Growth in Shareholder Rewards Outpaces Capex
Growth in Shareholder Rewards Outpaces Capex 200
150 Growth (%)
U.S. Banks’to Sensitivity to RisingRates Interest Rates U.S. Banks’ Sensitivity Rising Interest
100
50
0 S&P 500 Index Ex Financials*
Buybacks Dividends Cap Ex * Growth shown is the percent change between 12 months ending 9/30/2010 and 12 months ending 9/30/2016. Data is for the S&P 500 ex. Financials. Source: Computstat, Goldman Sachs, FactSet, as of 3Q16
WEAKNESS: GROSS DEBT NEARING HALF OF CAPITAL High Leverage Reduces Financial Flexibility On a book value basis, total debt has increased to nearly 50 percent of capital for S&P 500 non-financial companies—up from 40 percent just five years ago. While debt leverage is certainly lower when using the market value of equity as the denominator, book leverage remains an important indicator to rating agencies, commercial banks and bondholders alike. Furthermore, median debt to EBITDA has moved beyond 3 times for U.S. IG credits to levels just above the 2008-2009 peaks. Corporate management teams have a high relative cost differential and a significant tax incentive to utilize debt 3
Q4 2016 CORPORATE BOND COMMENTARY over equity. However, if the tax deductibility of interest expense is eliminated as proposed, then bond issuance may decline over time; this decline could occur particularly if interest rates continue to rise, which may slow the excess accumulation of debt. Cash repatriation by multi-nationals with large overseas cash hoards could also slow debt incurrence, as liquidity is tapped. S&P 500 Non-Financial Book Leverage S&P 500 Non-Financial CompanyCompany Book Leverage 50
Percent (%)
40 30
Energy and Finance Led Returns in 4Q16 For the third quarter in a row, Energy sector bonds outperformed the IG corporate bond index. Specifically, energy bonds had an excess return of 1.75 percent and outperformed the index by 106bps in the fourth quarter. Energy bond issuers benefited from sustained oil price stability in the fourth quarter brought on by announced OPEC production cuts and other factors. Financial bonds (e.g. finance, REITs, insurance and banking) outperformed due to the move higher in interest rates in 4Q16, which is expected to benefit net interest income if sustained. The Communications sector underperformed the corporate market by 73bps in 4Q16 on M&A activity and expected bond supply.
20
Returns by Sector Returns by Sector – 4Q16
10
2.0 1.5
0 2012
2013
2014
2015
Total Debt / Total Capital Source: Bloomberg, Standard & Poor’s Financial Services, LLC, as of December 2016.
RETURNS: SOLID CORPORATE MARKET EXCESS RETURNS Lower-Quality Bonds Outperformed in 4Q16 Based on a 75-85bps backup in benchmark 5-year and 7-year U.S. Treasury yields, respectively, the total return for the intermediate IG corporate market was negative 1.95 percent in the fourth 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 69bps of excess return in the fourth quarter. For the fourth quarter and the full year, lower-quality BBB-rated corporate bonds outperformed the broader IG corporate market. In contrast, higher-quality AA-rated bonds underperformed the corporate market for the same periods. Returns by Rating – 4Q16 Returns by Rating
0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0
Total Return Excess Return Source: Barclays Intermediate IG Corporate Index, as of December 30, 2016.
SPREADS: STEADY NARROWING IN 4Q16 AND FY16 BBB Corporates’ Outperformance Persisted Intermediate IG corporate bond spreads tightened by 8bps in the fourth quarter to an average option-adjusted spread (OAS) of 104bps—the tightest levels since May 2015. For the full-year 2016, corporate spreads were an impressive 35bps tighter. Lower-quality BBB corporate spreads tightened 21bps on average during the quarter, compared to AA-rated and A-rated bonds, which tightened by 8bps and 12bps, respectively. For 2016, BBB spreads tightened by a notable 78bps. The quality spread between AA-rated and BBB-rated corporate bonds ended the quarter and the year at 80bps— the tightest level since October 2014.
1.0 0.5 0.0 Percent (%)
1.0
2016
En er gy Co m pa ni Br es ok er RE s/ IT As se S tM gr s In su ra nc Ba e n Te kin g ch Co no rp lo or gy at e M Ba a sic rke t I n Ot du he st ry Co r In d ns um ustr ia er l Cy cli ca l Tr an Uti sp lity or ta Co Ca tio ns p n um ita er l Go No o nc ds Co yc m l m un ical ica tio ns
2011
ce
2010
an
2009
Fin
2008
Percent (%)
2007
-0.5 -1.0 -1.5 -2.0 -2.5 -3.0 BBB Corp.
IG Corporate
A Corp.
AA Corp.
Total Return Excess Return Source: Barclays Intermediate IG Corporate Index, as of December 30, 2016.
At current valuations, IG corporate spreads are slightly tighter than the long-term median (120bps) excluding periods of U.S. economic recession. Spreads are close to their post-financial crisis tights, but demand remains strong and we expect spreads to be rangebound in 2017.
4
Q4 2016 CORPORATE BOND COMMENTARY Corporate Quality Spreads
MARKET TECHNICAL: A GLOBAL YIELD COMPARISON Nominal Yields Favor U.S.-Denominated Corporates
Low Rates Have Have Driven HighHigh Borrowing but M&A Low Rates Driven Borrowing but M&AHas Has Slowed Slowed 3000 2500
$ Billions
2000 1500 1000 500 0 FY15
FY16
4Q15
4Q16
U.S. IG Corporate Bond Issuance U.S. Mergers & Acquisitions Bloomberg, as of December 30, 2016.
5% 4% 3% 2% 1%
16 4Q
16 2Q
15
15 4Q
2Q
14
14 4Q
2Q
13 4Q
2Q
13
0% 12
For 2016, robust IG corporate bond issuance of $1.35 trillion was slightly above 2015, as low interest rates continued to encourage record-level borrowing. U.S. M&A volume of $701 billion in 4Q16 declined about 22 percent year-over-year, reflecting a combination of elevated valuation multiples, increased antitrust scrutiny and global economic uncertainty. For FY16, M&A declined 18 percent to $2.3 trillion.
A Notable Yield Divergence in Global IG Credit
A Notable Yield Divergence in Global IG Credit
12
U.S. IG corporate bond issuance of $230 billion in the fourth quarter was about 15 percent lower on a year-over-year basis. The sharp move higher in interest rates and elevated volatility during the fourth quarter contributed to a slightly less favorable market for primary corporate bond issuance. The Financial sector accounted for 45 percent of issuance volume, based partly on future TLAC needs, refinancing needs and Yankee bank issuance. The Consumer Staples and discretionary sectors accounted for 15 percent and 9 percent, respectively, driven by M&A related bond issuance.
4Q
MARKET TECHNICAL: SUPPLY AND M&A Supply Was Up While Merger Activity Slowed
2Q
AA A BBB Source: Barclays Intermediate Corporate Index, as of December 30, 2016.
11
6
6
De c-1
6
No v1
6
t-1 Oc
6
6
16
Se p1
gAu
-1 Ju l
6 -1
6
Ju n1
ay M
6
6
-1
Ap r-1
ar M
6
Fe b1
Ja n1
De c-1
5
50
11
100
4Q
150
U.S. dollar-denominated IG corporates exhibit a significant nominal yield pickup relative to eurodenominated corporates. The yield differential, which began to widen in late 2012, is still notable. U.S. intermediate corporates yielded 3.5 percent, while Europe yielded 0.8 percent and Japan yielded 0.2 percent at the end of the fourth quarter. Not coincidentally, foreign purchases of U.S. corporate bonds spiked in 2013 and have remained strong since then, as global investors looked 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. The slowdown in economic growth in Europe also makes the U.S. corporate market an attractive alternative. However, U.S. dollar hedging costs are rising and offsetting the nominal yield differential.
2Q
200
10
OAS (bps)
250
4Q
300
Yield-to-Worst (%)
Corporate Spreads
U.S. Corporate Bond Index Euro Corporate Index Japan Corporate Index Source: The BofA Merrill Lynch Corporate Indices, as of December 30, 2016.
MARKET TECHNICAL: U.S. AND FOREIGN FLOWS Solid Flows into Taxable and IG Funds in 4Q16 Taxable bond and exchange-traded bond funds reported net inflows of $23 billion in 4Q16. Inflows slowed in the fourth quarter, as interest rates and equity markets have moved higher. For 2016, taxable bond funds reported net inflows of $162 billion, including $84 billion going into the IG category. It remains to be seen whether or not fund flows, an important source of demand for taxable bonds, can remain healthy given the Fed is expected to further lift short-term interest rates in 2017.
5
Q4 2016 CORPORATE BOND COMMENTARY
4.0
30000
3.5
25000
3.0
20000
2.5
15000 10000
1.5
0.5
0
0.0
Taxable Bond Mutual Funds + ETFs Investment Grade Bond Funds Source: ICI, as of December 30, 2016.
Strong Flows into Corporates from Foreign Investors Another important trend in gauging demand is the net purchase of U.S. corporate and foreign bonds by foreign residents. In fact, purchases of U.S. corporate bonds by foreign residents have been quite strong over the last few years. In 3Q16, foreigners bought almost $400 billion of U.S. corporate and foreign bonds at a seasonally adjusted annual rate, per Fed data. Elevated U.S. currency hedging costs for foreign investors is an offset that may slow these flows at some point. Foreign Demand Is a Key Theme and Positive Technical for Foreign Demand Is a Key Theme and Positive Technical the U.S. Corporatefor Bond Market the U.S. Corporate Bond Market 400
300
200
100
0 2013
2014
2015
U.S. Insurers
De c16
No v16
O ct -1 6
Se p16
Au g16
Ju l-1 6
Ju n16
M ay -1 6
Ap r-1 6
M ar -1 6
U.S. Banks
Fe b16
Ja n16
2.0
1.0
5000
-5000
Foreign Flows ($ Billions)
and Banks are Large Holders of Bonds Insurers and Insurers Banks are Large Holders of Bonds
($ Trillions)
U.S. Fund Flows ($ Millions)
High-Grade Fixed Income FlowsFlows Slowed Slightly in in 4Q16 High-Grade Fixed Income Slowed Slightly 4Q16 But Remained Robust FY16 Robust for FY16 Butfor Remained
U.S. Insurance and Banking Invested Bonds Source: FDIC, NAIC, as of December 2016.
SPECIAL INSIGHT: TAX REFORM: IMPACT ON CORPORATES Impacts Vary Based on Sector President-elect Trump’s victory has potential credit implications for a number of corporate sectors. The impact of Trump’s win will depend on the likelihood of real Federal policy shifts and changing regulations and laws. We think implications may initially be positive for financial companies, but more mixed for industrials, depending on the sector. Below, we outline the impact of certain tax reform measures on various parts of the corporate market. • Multinational companies: Trump has proposed cutting corporate tax rates, eliminating the tax deductibility of interest and implementing a one-time tax holiday to repatriate overseas corporate earnings and cash. These measures would be positive for after-tax earnings and could increase the cash coffers of corporations that repatriate overseas monies, thus slowing debt issuance over time. Much of the impact on multinationals depends on how liquidity is utilized (e.g., capital expenditures, share buybacks, dividends, debt reduction, or other usage).
3Q16 SAAR
Net Purchases of U.S. Corporate Bonds by Foreign Residents Source: Federal Reserve Flow of Funds, SAAR, as of 3Q16.
Insurers and Banks have a Large Appetite for Credit U.S. insurance companies and FDIC-insured commercial banks hold approximately $6.4 trillion of bonds between them. This ownership provides a steady source of demand for bonds through reinvestment of coupon income and funds from debt maturities. Assuming an average coupon of three percent, and three percent of bonds maturing each year, almost $400 billion is available for re-investment annually—creating a potent source of steady demand for IG corporate bonds.
• Banks/Insurers: Trump and certain Republicans have proposed repealing the 2010 Dodd-Frank Act. This could cause regulatory oversight, compliance and risk management costs to decline for banks and insurers. While this could support earnings near-term, longterm, this could create more credit risk by allowing banks and insurers to take greater risks and have thinner capital cushions. • Exporters/Importers: Trump has indicated a desire to renegotiate trade agreements and potentially levy tariffs or institute border taxes. A tariff could prompt the U.S. dollar to rise, negatively impacting U.S. exporters. A border-adjusted tax could also negatively impact Retail 6
Q4 2016 CORPORATE BOND COMMENTARY or Auto sectors where goods are imported to be sold in the U.S. However, the new trade protections could positively impact U.S. manufacturers using American parts and labor (such as Steel and Mining). • Construction/Defense: On the Construction side, Trump has discussed increasing infrastructure investment, which could be positive for construction machinery firms. On the Defense side, Trump has called for eliminating the defense sequester, which may be positive for some Defense companies; however, recent comments indicate some concern over high-cost military programs. • Pharmaceutical: The new administration could repeal the Affordable Care Act. This could impact some Pharmaceutical credits, as more than 20 million Americans could lose healthcare. We do expect a more favorable regulatory environment for businesses, but rhetoric suggests less patience for extraordinarily high drug prices. • Energy: Large energy firms could benefit from a new energy plan from Trump that would roll back subsidies on renewable energy projects and allow for greater investment in pipelines and fossil fuels. Additionally, potentially less stringent environmental regulations could allow for expanded drilling opportunities.
Overall, we think that the companies we invest in are highly creditworthy and remain well positioned to weather changing U.S. and global political landscapes.
BRECKINRIDGE STRATEGY Look to the Long Term While corporate debt leverage is very high, potential policy and regulatory adjustments could ease tax rates, and the U.S. administration’s proposed fiscal stimulus measures might extend the economic cycle by a year or two, and therefore we don’t expect a recession over the next 12-18 months. As mentioned, loose monetary policy is no longer a tailwind for corporate credit, but U.S. government fiscal policy could replace monetary policy as a tailwind for credit if corporatefriendly policies are implemented. But this is uncertain, and indeed some possible future trade policies (e.g. tariffs) could be credit negative to U.S. multi-nationals in certain sectors. In today’s uncertain environment, we believe that management teams of larger, global corporations should focus on long-term strategy and not be swayed by the 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 favorable 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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