Year End Credit Update

Monthly Commentary

January 11, 2019

2018 ended up being a tumultuous year for risk assets. While the experience during the first three quarters of the year was one of low volatility and relative stability in credit spreads, the final quarter saw significant spread widening. After starting the year near the post crisis tights of +89 basis points (bps) over Treasuries, the credit index OAS ended the year at +143 bps. The majority of the spread widening – 43 bps out of a total of 54 bps – occurred in the fourth quarter, marking the worst year for total returns since 2008 (-2.11%) and worst year for excess returns ( -2.80%) since 2011. Investor sentiment took a sharp U-turn as late cycle fears, U.S./China trade wars, Brexit, Fed policy and tightening liquidity conditions were blamed for the derailment in credit spreads. Moreover, the technicals, which have been the main drivers of credit performance over the last decade, have turned. The QE-tailwinds, which propped up the markets and triggered consecutive years of QE-led spread tightening while masking vulnerabilities, including peak levels of corporate leverage and the massive growth in the credit markets, have become headwinds. While tax cuts and overseas earnings repatriation were positives, that stimulus came late in the cycle, when spreads were already tight, leverage high, and the size of the IG debt markets massive. As such, we have maintained a conservative approach to credit, which includes investing in the more senior parts of the capital structure and in less cyclical sectors. As spreads widen and the opportunity set grows, so too will our credit exposure approach neutrality, in line with our mean-reverting, dollar-cost-averaging investment philosophy.

2018 Credit Themes: Higher yields, wider spreads, increased volatility, supply/demand imbalance, tighter liquidity, weaker fundamentals including peak leverage, beta decompression and U.S. bank outperformance vs. Europe.

Central Bank Balance Sheet Reduction The Path From QE to QT.

Source: Wells Fargo

YTD Total Returns For Various Fixed Income Classes

Source: Bloomberg Barclays

Annual Excess and Total Returns for the Credit Index:
2018 worst year for total returns since 2008, worst year for excess returns since 2011.

Source: Bloomberg Barclays

Credit Index Yields and Spreads:
Yields were 90 bps higher on the year, spreads were 54 bps wider.

Source: Bloomberg Barclays

Supply Outweighed Demand for Credit

Source: BAML

Credit Index Market Value
IG credit market value fell by $172 bln in 2018 on a drop in valuations and lower net supply

Source: Bloomberg Barclays

Sector Performance

The investment grade credit index widened 54 bps in 2018, ending the year at an OAS of +143 bps over Treasuries. The range in spreads was 62 bps in 2018, touching the post crisis tights of +81 over Treasuries in February and ending the year at +143 bps. The 20-year average for the credit index is +150 bps, so from a valuation standpoint, spreads ended the year close to the historical mean. The worst performing sectors were tobacco (+111 bps on the year on M&A related re-leveraging) autos (+110 bps), independent energy (+85 bps), life insurers (+88 bps) and diversified manufacturing, led by GE (+87 bps). Best performing sectors on the year were generally those non-cyclical sectors that did not engage in leveraging transactions. Those sectors included munis (+22 bps), retailers driven by highly rated names like WMT (+ 38 bps), pharma (+44 bps), wirelines driven by VZ and ATT (+46 bps) and tech (+46 bps). Overall, the BBB vs. single A basis diverged, with most of that divergence occurring in the fourth quarter as cyclicals (autos, metals, chems, energy) began to underperform. Performance in the single A universe was bifurcated however, as $233 bln worth of fallen single As contained the worst YTD performers, including GE (+183 bps wider ), Abibb (+100 bps) and MO (+121 bps). The majority of the downgrades in the fallen A cohort were a consequence of re-leveraging transactions, most of them M&A driven (MO, Abibb and UTX for example). As such, the BBB portion of the credit index has ballooned to 46.79%, up from ~30% at the start of the cycle.

Excess and Total Returns for December and the Full Year

Source: Bloomberg Barclays

YTD OAS Changes:
Cyclicals Underperformed, Reversing Outperformance in 2017

Source: Barclays Capital

December OAS Changes

Source: Barclays Capital

European Banks Underperformed

Source: Bloomberg Barclays

BBB/A Basis:
The spread between BBBs and As widened 28 bps, ending the year at 78 bps.

Source: Bloomberg Barclays

The BBB portion of the credit index has grown to 46.79%

bbb’s as % of Credit Index

Source: Bloomberg Barclays

No Place to Hide:
Fallen single As totaled $233 bln in 2018 led by GE (49 bln) and Abibb (65 bln).

Source: Bloomberg Barclays

Investment Grade Supply

After eight consecutive years of growth, supply decreased both on a gross and net basis in 2018. Gross investment grade supply totaled $1.237 trillion, down 11% vs. 2017 while net supply of $590 bln was down 25% vs. the previous year. The technology sector was the biggest driver of the drop in supply as issuers with heavy overseas cash balances (like AAPL and MSFT) did not tap the debt markets in 2018. Record M&A-related supply volumes grew 39% to a record $255 bln, led by the healthcare and food & beverage sectors. The largest deals (M&A-related) came from CVS/AET ($40 bln) Comcast/SKY ($27 bln) and Cigna/ Express Scripts ($20 bln).

Annual Gross and Net Supply

Source: Bloomberg Barclays

M&A Supply Grew 39%

Source: BofA Merrill Lynch Global Research

M&A-Related Supply by Sector

Source: BofA Merrill Lynch Global Research

Gross Annual Supply by Sector

Source: BofA Merrill Lynch Global Research

Change in Supply vs 2017
The technology sector saw the largest year-over-year decline.

Source: BofA Merrill Lynch Global Research

 

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