For US credit markets, while January had provided investors with some optimism that the strength and stability of 2017 would carry over into 2018, the tone has now shifted to one of trepidation. A new Federal Reserve (Fed) Chairman, reports of rising inflation, mounting political/geopolitical risks and the resulting volatility are unnerving investors.
Investment-grade (IG) bonds have underperformed other asset classes so far this year, including equities and high-yield bonds (see Exhibit 1). There are practical aspects to this, namely that IG bonds are longer-duration instrume
nts, which magnifies any losses incurred through spread widening.Exhibit 1: Asset class returns so far this year (%)
Note: IG credit is the Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade index; HY credit is the Bloomberg Barclays US High Yield - Corporate index. Source: FactSet, BNP Paribas Asset Management, as of 05/04/2018Exhibit 2: US IG and HY spreads
Note: IG credit is the Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade index; HY credit is the Bloomberg Barclays US High Yield – Corporate index. Source: FactSet, BNP Paribas Asset Management, as of 05/04/2018
Credit markets: the technical factors
We have seen signs of a reversal of the strong technical factors that underpinned credit markets over the last few years. These include
- lower demand from corporate treasurers on the back of tax reform
- higher cross-currency hedging costs making it more expensive for foreign investors to invest in the US
- lower retail demand following losses in February.
The data backs this up. Total inflows into high-grade bond funds were USD 4.3 billion in February, down from USD 31 billion in January and also well below the 2017 monthly average of USD 24 billion. Credit-only funds saw USD 2.9 billion of outflows for the month, according to JPMorgan.
Not all the technical factors are bad, however. As of 6 April, 10-year Treasury yields have risen by about 42bp in the year to date. This extra yield increases demand from liability-driven entities such as insurance companies and endowments, which are typically significant buyers in this market.
IG bond issuers have been very active in the new issue market over the last few years, with each successive year seeing record issuance. Conversely, we have seen restraint over recent weeks as the buying community pushed back on some new issues via pulled deals and larger spread concessions.
In addition, the repatriation component of tax reform should reduce the debt funding needs of some of the largest companies, particularly in the technology sector, as the newly-domiciled cash can be used for share repurchases and capital expenditure. This could leave 2018 with less primary market activity than 2017. This is a positive for supply/demand technical factors.
Investment-grade credit markets: the fundamentals
IG fundamentals tell more of a mixed story. Fourth-quarter 2017 company earnings were mostly solid, with revenues up by 8.5% from the prior year, driven by improvements in the energy sector. Cash flow grew by 13%, benefiting industrial leverage metrics. Growth was partly offset by a 6.3% rise in debt.
The strong results improved the core year-on-year credit ratios across the board: average profit margins climbed by 1.8% to 29.5%, average debt declined by 0.3x to 2.8x and interest coverage rose by 0.3x to 10.2x (source: JPMorgan).
This paints a strong fundamental picture for the rest of the year, particularly when considering the favourable US macroeconomic environment.
In the more adverse fundamental backdrop, revolving around late-cycle variables to the economy, it can be noted that, for instance, leverage remains at the highs of the cycle, as shown in Exhibit 3.Exhibit 3: Leverage among corporate issuers is currently at its highest in this credit cycle Source: Wells Fargo Securities, as of 01/12/2017
Leverage was contained thus far as robust global economic growth and strong company earnings supported credit ratings from Moody’s, S&P and Fitch. However, typical late-cycle M&A has left some companies exposed to tail risk in the event of an economic downturn.
The tail risk issue could be exacerbated by various possible macroeconomic shocks. Examples include
- a trade war on the back of US-imposed tariffs
- upticks in inflation with higher interest rates that increase market volatility and pressure asset prices
- any number of potential geopolitical shocks.
Investment-grade companies that borrowed heavily for M&A with the promise to reduce their debt burden through cash flow generation are most at risk of losing the coveted IG ratings should the economy turn and earnings decline, leaving open the possibility of the need to refinance a large amount of debt at higher yields.
All of this suggests a decent IG backdrop for most of the year, with more uncertainty as we progress further through the long-running cycle. Ultimately, this should bode well for active IG credit portfolio management as the need to identify the companies that have stable cash flows and fiscally-prudent management teams becomes more critical.
The case for high-yield
History tells us that high-yield (HY) should outperform other fixed-income asset classes in times of rising interest rates. This is due to the lower duration and greater spread component of the total yield, particularly when compared to IG credit (see Exhibit 4). So far in 2018, even with higher market volatility, HY has outperformed IG.Exhibit 4: Relative performance: government bonds and credit
Note: GB yield is for US 10-year Treasury; GB index is the Bloomberg Barclays US Aggregate Government – Treasury index; IG is the Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade index; HY is the Bloomberg Barclays US High Yield – Corporate index. Source: Bloomberg, BNP Paribas Asset Management, as of 05/04/2018
Similar to the environment for IG bonds, the technical backdrop for high-yield is mixed. The headlines highlight continued outflows in the asset class. This is illustrated in Exhibit 5.Exhibit 5: US high-yield and leveraged loans - monthly flows (USD bn) Source: Wells Fargo Securities, as of 29/03/2018 However, this only explains part of the technical picture. Despite fund outflows, the asset class has been supported by internally generated cash flows via coupon payments and corporate actions, e.g. called bonds and tender offers (see Exhibit 6). Exhibit 6: HY cash flows from coupons, called/tendered bonds and retail fund flows (USD bn) Source: Wells Fargo Securities, as of 02/04/2018
The figure highlights the cash flow support of the asset class which can provide stability during bouts of volatility, albeit to a lesser extent if there is a prolonged downturn.
Similar to IG, the near-term fundamental outlook bodes well for HY as earnings reports highlight increasing cash flow and the energy sector continues to recover from the substantial decline in early 2016. Also, most high-yield issuers have been focused on balance sheet management through tenders of higher-coupon debt and eliminating near-term maturities by issuing longer-dated securities. The improved liquidity profiles of HY issuers provide a cushion against a brief market downturn.
There has been some focus on tax reform and its impact on high-yield fundamentals. JPMorgan has noted that for 75% of HY companies, the benefit of a lower tax rate and the ability to depreciate more of their capital expenditure outweigh their inability to fully deduct interest expense. For the 25% worst-off companies, most will see free cash flow impacted by less than 5%. In addition, most of the negative impact is contained in the CCC rating bucket.
In summary, the high-yield credit markets have a mix of technical and fundamental attributes that bode well in the current US economy – even at current spreads that remain tighter than average. The critical risk, as always, remains the tail event that leads to a decline in economic output and an increase in the default rate. Similar to the investment-grade credit markets, as the volatility persists and the Fed’s monetary backstop shrinks, sector and issuer selection will be essential for outperformance.
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