February Credit Update

Monthly Commentary

March 06, 2017

February brought another good month for risk assets. U.S. equities touched new peaks, volatility (as measured by the VIX) remains near the lows and credit spreads tightened 6 basis points. Demand for spread product remained robust as inflows into the asset class continued and IG supply saw a sharp decline vs. January’s record number (as blackout periods related to earnings reduced supply volumes).

The market is clearly focusing on the positives of President Trump’s economic agenda – that includes tax reforms/cuts, a repatriation holiday, infrastructure spending, and less regulation. What is unclear at this point is how the government plans on paying for all this stimulus. Some of the offsets discussed include a border tax adjustment, though that appears to be unpopular with Congress. Another possible mitigating option to tax cuts could be a change or elimination of interest deductibility – meaning corporations would no longer be able to deduct (from taxes) the interest they pay on their debt. While this is all conjecture at this point, the implications of a removal of interest deductibility would likely mean less corporate debt issuance, as the after-tax cost of issuing debt increases. A repatriation tax holiday could also reduce debt issuance needs, with the biggest beneficiaries being the tech and health care sectors, as those sectors have significant amounts of cash held overseas. It is estimated that about $1 trillion in cash is held overseas by U.S. IG issuers. While a good portion of that cash, if repatriated, would likely be used for share buybacks, dividends, and/or M&A, it could still reduce debt issuance needs for these issuers. The flip side to this expansionary agenda of corporate tax cuts, defense and infrastructure spending and less regulation is the re-stoking of animal spirits, which would also have the effect of prolonging the credit cycle at time when leverage metrics are already at peak levels and valuations are stretched.

Q4 earnings: With Q4 earnings 97% complete, EPS growth for the S&P 500 stands at 6.48% (y-o-y), with improvement over Q3 and a second consecutive quarter of positive growth (after five consecutive quarters of negative growth). Energy was less of a drag on earnings as commodity prices recovered. Sectors posting the strongest year-over-year EPS growth were REITS, tech, financials and utilities. Given the improvement in EBITDA, preliminary data on credit metrics for the IG universe show that leverage likely stabilized. We will have more details in next month’s credit update.

Index changes: The Barclay’s Credit Index made some changes to the minimum amount outstanding for Treasury, governmentrelated and corporate securities in the US Agg. The minimum amount outstanding will be raised to $300 million from $250 million. As a result, approximately 799 securities, totaling $223 billion in market value (3.7% of the credit index), will fall out of the credit index on April 1. From a sector standpoint, the biggest impact (on a % basis) will be felt in the utility and muni sectors. The utility sector will shrink by 15% (~ 213 securities/$58 billion market value) while local authorities (comprised mainly of muni debt) will shrink by 17%.

S&P 500 Q4 earnings – Year-over-Year EPS Growth

Source: Bloomberg Barclays

Cash held overseas by U.S. companies. Sectors that would benefit the most are tech and health care.

Source: BofA Merrill Lynch Global Research

Source: BofA Merrill Lynch Global Research

Fund Flows: Strong YTD Flows into Fixed Income

Source: BofA Merrill Lynch Global Research

YTD Flows for Week Ending 3/1/17

Source: BofA Merrill Lynch Global Research, EPFR Global

Credit index performance: The credit index tightened 6 basis points in February, the fifth consecutive month of spread tightening. The index OAS of +110 basis points over Treasuries is now just 17 basis points off the post crisis tights of +93 touched in June 2014. The yield on the index dropped 9 basis points to 3.18% in February, with a YTD range of 18 basis points (3.146% - 3.325%). Of the 5 broad sectors, fins and sovereigns outperformed. Bank spreads tightened 8 basis points with performance evenly distributed among both domestic and Yankee banks. The one exception was French banks which experienced some volatility ahead of the April presidential elections, though spreads recovered to end the month unchanged.

Credit curves steepened in February as the front end outperformed. Higher front end yields coupled with relatively flat credit curves in sectors like financials has led to increased demand for front end paper. The dislocations that were caused by money market reforms (implemented on 10/14/16) have since remediated with the 1-2 year credit curves now positively sloped. The reach for yield/spread theme continued as higher beta, lower rated sectors generally outperformed. A vs BBB spreads compressed another 2 basis points to 54 bps apart and are now a stone’s throw away from the post crisis tights of 44 bps. Metals were the best performing sector in February and year to date, posting excess returns of 2.01% and 4.06% respectively. Commodity price remediation coupled with bullishness over infrastructure spending have been catalysts for spread tightening. Additionally, companies continue to conduct liability management exercises in order to right size the balance sheet. BHP executed a $2 billion bond tender in February and Barrick Gold announced plans to reduce debt by another 35% by the end of 2018 (via free cash flow and asset sales).

February Credit Index Returns

Source: Bloomberg Barclays

Credit Index Spreads and Yields

Source: Bloomberg Barclays

A vs. BBB Spreads Nearing the Tights

Source: Bloomberg Barclays

French Sovereign Spreads Widened Ahead of Presidential Election

Source: BofA Merrill Lynch Global Research

IG supply: After a record month in January, investment grade issuance came in at $96 billion, in line with the February average of the past six years. New issue concessions were actually negative in February ( avg of -1 bp), causing secondary spreads to tighten after deal pricing. Supply related to M&A was negligible as the backlog of pending deals has diminished. Net M&A related supply was actually negative when taking into account the mandatory call on the $10.2 billion Aetna bonds issued in June of last year to fund the Humana acquisition. After an 18-month regulatory review process, Aetna and Humana terminated the merger agreement after a federal judge blocked the deal on anti-trust grounds. Looking ahead, a more friendly regulatory environment, tax reform and the potential for a repatriation tax holiday could revive the M&A calendar – time will tell.

IG Monthly Issuance

Source: BofA Merrill Lynch Global Research

New Issue Concessions

Source: BofA Merrill Lynch Global Research

M&A Backlog

Source: BofA Merrill Lynch Global Research

 

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