March Credit Update

Monthly Commentary

April 06, 2018

March was another volatile month for the credit markets as an escalating trade war and geopolitical risks moved front and center. These macro pressures, coupled with softening demand for credit, resulted in wider spreads. On the demand side, inflows into ETFs and mutual funds have decelerated (as returns have been negative) while overseas buying has tapered. Currency hedging costs for foreign investors have increased, making U.S. credit less attractive on a relative basis, especially vs. Euro credit. On the supply side, a heavy new issue calendar as well as the continuation of front-end selling out of Asia and by corporations (looking to repatriate earnings) led to a supply/demand imbalance. The credit index OAS of +103 basis points over Treasuries was 12 bps wider on the month and has traded in a 22 basis point range (+81 – +103) during the first three months of the year. That compares to a range of 29 basis points for all of 2017.

Credit Index Yields and Spreads:

Credit index yield of 3.68% highest since 2011.

Source: Bloomberg Barclays

Less Demand for credit as fund flows and foreign buying have decelerated.

Affiliate Buying

(proxy for foreign buying) is down 47% from a year ago

Note: Net dealer-to-affiliate volumes are correlated with foreign buying/selling. Negative numbers indicate foreign buying.
Source: BofA Merrill Lynch Global Research, TRACE

IG Mutual Fund Flows

– down 66% YoY

Note: Net dealer-to-affiliate volumes are correlated with foreign buying/selling. Negative numbers indicate foreign buying.
Source: BofA Merrill Lynch Global Research, TRACE

USD Currency Hedging Costs have increased for JPY and EUR investors.

USD Annualized Hedging Costs/Gains (3M Forward)

Source: Wells Fargo Securities, Bloomberg L.P.

U.S. credit relative value vs. Euro credit. Adjusting for the currency hedge and duration, U.S. credit is no longer cheap to Euro credit.

Rich/Cheap (EUR)

Source: Wells Fargo Securities, Bloomberg L.P.

Index Performance: The credit index OAS widened 12 basis points in March, after 9 basis points of widening in February. At an OAS of +103 basis points over Treasuries, the credit index is 14 bps wider YTD and 22 bps wide of the recent tights (+81 on 2/2). Lower Treasury yields and wider spreads had a mixed impact on the returns which were +.31% (total return) and -0.81% (excess return) on the month. For the year, returns are -2.13% (total return) and -0.66% (excess return) while the index yield of 3.68% is 49 basis points higher.

March credit performance was generally weak across the board with the exceptions of munis, which have held in quite well throughout the recent volatility. The sector tends to be higher quality and lower beta and has benefited from lack of supply. Munis are also the best performing sector on the year (-4 bps), followed by wirelines (-1 bp,) which is dominated by two issuers VZ and AT&T. M&A related supply coupled with already large capital structures has pressured spreads for these two issuers over the past 2 years. Spreads have remediated over the past several months as supply related pressures have eased. AT&T is in the midst of a court battle with the DOJ over the proposed acquisition of TWX. There were $22 bln in bonds issued (to fund the acquisition) with special mandatory redemption language. A good portion of these will likely be redeemed as the case will not be settled by the 4/22/18 merger deadline. The worst performing sectors on the month were paper (+21 bps), led by IP on increased event risk (IP trying to acquire Smurfit), and life insurers (+21) which tend to underperform during times of market volatility. Energy as a whole performed in line with the overall market though midstreams underperformed (+19) on the heels of the recent FERC ruling which proposes to eliminate the tax allowance baked into the rates MLPs (which are non-tax paying entities) charge on some of their pipelines. In response to this ruling, we expect MLPs to simplify their capital structures by collapsing their gp/lp and converting into C corps, thereby becoming tax paying entities which are not subject to this rule change. From a long term perspective, simplification, including the elimination of Incentive Distribution Rights, is a positive for bondholders.

March Credit Index Returns

Source: Bloomberg Barclays

Monthly Index Returns

Source: BofA Merrill Lynch Global Research

Sector Spread Performance (YTD and MTD)

Source: BofA Merrill Lynch Global Research

March Investment Grade Supply: New issues volumes totaled $124 bln, a big number though in line with March volumes over the past two years. The majority of supply came from industrials ($94.6 bln), driven by $50 bln in M&A related issuance. CVS – the $40 bln multitranched deal to fund the AET acquisition – was not only the biggest deal this month but was also the best performer (-20 bps from new issue) as the deal priced with a significant new issue concession. New issue concessions as a whole improved to 12 basis points in March (vs. 5 bps the previous 2 months), driven by overall market weakness. The pipeline of pending M&A related supply has increased, especially in the healthcare and food/beverage sectors. Recently announced deals include Cigna (buying ESRX) and Keurig (buying DPS). Deals rumored to be in progress include WMT/HUM, Shire/Takeda, CBS/VIA and Target/Kroger. 

Monthly IG Supply

Source: BofA Merrill Lynch Global Research

New Issue Concessions

Source: BofA Merrill Lynch Global Research

Enterprise Value of Pending IG M&A Deals

Source: BofA Merrill Lynch Global Research

M&A-Related Supply Volumes

Source: BofA Merrill Lynch Global Research

 

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