IG credit spreads were modestly weaker in October, underperforming the euphoria exhibited in the equity markets. Overall, sentiment remained bullish as a strong earnings season outweighed the macro risks, including a real estate led Chinese economic slowdown, inflationary pressures, and the impending end of Fed asset purchases. The debt ceiling can has been kicked down the road and Congress continues to negotiate a contentious budget deal. Inflationary pressures continue and tighter monetary policy is looming, yet valuations indicate the markets are not too concerned with these risks. Thematically, the same forces that propelled risk assets for the better part of the last decade persist. The world is awash with central bank-driven liquidity and record government spending. There remains $10.7 trn of negative yielding debt globally, down from $17.8 trn at the start of the year.

Q3 earnings have been strong, tracking at a 36% YoY growth rate with about 70% of the companies in the S&P 500 having reported. Despite record mentions of labor cost and supply chain issues, margins were resilient as higher sales generally outweighed increased input costs. Consumer spending stayed strong despite higher prices and the expiration of enhanced unemployment benefits. The U.S. savings rate of 9.4% remains elevated, down from 26% in March of this year but 2% higher versus pre-pandemic (2019) levels, as consumers have not yet spent all of their stimulus checks. In terms of corporate balance sheets, record profits will drive leverage for the non-financial universe down to pre-pandemic levels. Ratings upgrades have surpassed downgrades for two consecutive quarters and a significant number of rising stars are expected after a record year of fallen angels in 2020. Corporate cash and liquidity are near peak levels and profit margins continued to expand despite cost pressures. While fundamentals may be more indicative of a mid-cycle phase, credit valuations are late cycle. Looking ahead, credit metrics will also be driven by the willingness of corporate management teams to exercise balance sheet discipline in the face of record low financing costs. M&A activity has already begun to accelerate and share buyback authorizations have eclipsed pre-pandemic levels.

Banks posted another strong quarter of earnings on robust capital markets activity and continued reserve releases on the heels of a strong economic rebound. Net income growth for the big 6 averaged +23% YoY and +7% QoQ. Investment banking revenues were up +55% YoY, driven by the best quarter in M&A Advisory in years. Credit costs remain low as high savings rates (partially thanks to stimulus checks) and a strong economic recovery prompted a reversal of loan loss reserves taken during the pandemic. JP Morgan noted that net charge offs were the lowest ever while Bank of America said its NCOs were the lowest in 50 years. Within the IG credit universe, banks offer compelling relative value. Record YTD issuance in the sector has created opportunities to add exposure to these regulated, systemically critical, well capitalized banks at spreads comparatively wider versus the overall credit spectrum. The growth in bank balance sheets coupled with the expiration of the supplementary leverage ratio (SLR) exemption has been the main driver of increased debt issuance. From a fundamental perspective, the sector benefits from extensive regulatory oversight, including strict capital requirements that are tested annually. To underscore this point, let us recall the Fed- mandated suspension of share dividends and cap on dividend payments during the height of the pandemic. Capital and liquidity remain healthy with CET1 ratios averaging 12.9% (down slightly from Q2) and LCRs (liquidity coverage ratios) averaging 122%.

Market Themes

• IG credit spreads have been range bound as volatility remains at/near historic lows. At an OAS of +82 basis points (bps), valuations are close to decade tights and ~ 50 bps through the 20 year non-recessionary average.
• Credit metrics for IG issuers improved on the heels of strong Q3 earnings growth. Corporate cash and liquidity are near peak levels while profit margins continued to expand. While leverage is coming down to pre-pandemic levels, it remains near historic highs.
• COVID-sensitive and cyclical sectors have significantly outperformed YTD. More recently, spread performance has stalled as valuations approach pre-pandemic tights. Energy names were largely unchanged in October despite the 11% rally in oil (WTI). This highlights the asymmetric risk that exists as spreads reach their floor.
• The flattening of the Treasury curve had little impact on credit curves. 20-30’s rate curve inverted for the first time since 20-year Treasury issuance was reintroduced in 2020. 10-30’s credit curves were flatter on the month while 5-10’s curves were moderately steeper.
• The Chinese real estate debt crisis had little to no impact on IG credit valuations. Three more high-yield developers missed interest payments in October, resulting in further decompression between China IG versus HY debt.

Q3 Earnings Have Been Strong Despite Inflationary Cost Pressures

S&P 500 consensus earning and sales growth expectations by sector

Source: FactSet, BofA U.S. Equity & Quant Strategy

Supply Chain (+412%) and Labor Mentions (+320%) Skyrocket

S&P companies’ mentions of inflation-related words on earnings calls (2Q04=100; 2004-present)

Source: BofA Global Research
Note: Words included in each category: price: “price”, “pricing”; materials: “material”, “commodit”; transportation: “transportation”, “shipping”, “freight”, “logistic”, “fuel”; labor: “labor”, “wage”, “worker”, “personnel”; supply chain: “supply chain”

Net Profit Margins at Peak Levels Despite Inflationary Cost Pressures

S&P 500 quarterly net margins ex-Financials (2012-3Q21E)

Source: FactSet, BofA U.S. Equity & Quant Strategy

Corporate Cash and Liquidity Near the Highs

Source: Bloomberg, Morgan Stanley Research

On the Heels of an Earnings Recovery, Credit Metrics Have Improved, Prompting Ratings Upgrades Which Have Surpassed Downgrades for Two Consecutive Quarters

Source: Goldman Sachs, Bloomberg

Cheap Funding for Corporate Issuers. Average New Issue Coupons for IG and HY Debt Are Near the Lows.

Source: Dealogic, Goldman Sachs Global Investment Research

M&A Volumes Are Accelerating

Source: MUFG, Institute for Mergers, Acquisitions and Alliances (IMMA), S&P Capital IQ, Dealogic, Bloomberg

Stock Dividends and Buybacks Also Accelerating

Source: Barclays, Compustat, FactSet, Bloomberg

IG and HY USD Chinese Corporates Continued to Decompress

Source: Bloomberg

Index Performance Recap

IG credit spreads experienced marginal weakness in October, widening 2 bps to an OAS of +82. The index yield of 2.15% rose 10 bps on higher front end risk-free rates, yet total returns were marginally positive on lower 30-year Treasury yields (yield curve flattening). Despite the flatter Treasury curve, 30-year corporates outperformed as term premiums remained stable. The 20-30’s Treasury curve inverted for the first time since 20-year Treasury issuance was reintroduced in 2020. Nonetheless, 10-30’s credit curves were flatter on the month while 5-10’s curves were moderately steeper.

Performance at the sector level was mixed, with some “reopening” trades outperforming (airlines -7 bps, lodging -4 bps), while others (midstream +2 bps, autos +3 bps) modestly underperformed. By and large, performance for the COVID-sensitive/cyclicals sectors has stalled as valuations approach pre-pandemic tights. Energy names were largely unchanged in October despite the 11% rally in oil (WTI). This highlights the asymmetric risk that exists as spreads reach their floor. From a longer-term perspective, energy prices tend to be quite volatile as supply/demand imbalances are typically met with higher production and/or demand destruction.

The two worst performing sectors in October, tobacco (+6 bps) and banks (+6 bps), are also the worst performers YTD (tobacco +12 bps, banks +2 bps). Bank underperformance is wholly related to supply technicals – as opposed to the fundamentals. The growth in bank balance sheets coupled with the expiration of the supplementary leverage ratio (SLR) exemption has been the main driver of record debt issuance. Fundamentally, bank earnings and capital levels are at/near their strongest levels in decades.

October Index Returns

Source: Bloomberg

October and YTD Spread Changes

Source: Bloomberg

Sector Spreads as of 10/29/2021 and Previous Cycle Tights (2/2/2018)

Source: Bloomberg

Treasury Yield Curve Flattened

Source: Barclays

Credit Curves Remained Stable. 5-10’s Were Marginally Steeper, 10-30’s Flatter.

Source: BofA Global Research

Banks Capital Ratios Actually Improved Through the Pandemic

Source: Federal Reserve Board, Form FR T-9C, Consolidated Financial Statements for Holding Companies

October New Issue Recap

IG gross supply totaled $120 bn in October, consisting of $81 bn financials and $39 bn industrials. The YTD gross supply number totals $1.32 trn, a 23% decrease versus 2020 but still comparatively higher versus 2019. Net supply (gross minus all redemptions) was $57 bn for the month, bringing the YTD total to $414 bn which is down 50% versus a record 2020.

AMR priced its first EETC since the pandemic. The A tranche (top of the waterfall) priced at 2.875%, or ~ +125 bps over Treasuries (9-year avg. life). The company was also able to price a B tranche at 3.95%, an equivalent spread of +270 bps over Treasuries (6-year avg. life). While the A tranche priced within 20 bps of its pre-pandemic tights, the B tranche priced with a much bigger discount versus pre-pandemic levels. The senior to subordinated spread difference of 150 bps is meaningfully wider than the 25 bp relationship that existed just prior to the pandemic. Keep in mind the average ratings for EETC senior tranches dropped from AA prepandemic to A post pandemic, a reminder of the inherent volatility that exists in this industry.

M&A related supply totaled $29 bn with the largest deal coming from AerCap, which issued $21 bn across several maturities to fund the GE Capital Aviation Services (GECAS) merger (5yrs priced at +125, 10 yrs at +165). The deal was widely anticipated and well received. With an order book of $70 bn, the bonds quickly retraced the 10 bps of new issue concessions – and then some.

Bank issuance resumed post earnings, totaling $48 bn in October and dominated by the big 6 ($24 bn). The largest bank issuer was Goldman, issuing a total of $9 bn across 3 maturities (5yrs priced at +78, 10yrs at +105). YTD, bank issuance for the big 6 (BAC, JPM, Citi, WFC, GS, MS) stands at a record $176 bn, already surpassing all of 2020.

YTD Big 6 Bank Issuance Already Surpassing Full Year 2020

Source: BofA

October Supply Consisted of $39.0 bn of Industrials and $81.3 bn of Financials

Source: Bloomberg, BofA Global Research

U.S. IG Gross Supply = $120.4 bn and Net Supply = $57.0 bn in October

Source: BofA Global Research, Bloomberg