March Credit Update

Monthly Commentary

April 08, 2019

Credit index spreads were stable in March despite the macro headwinds, Brexit overhang, Turkey volatility, and late cycle fears. Moreover, the 3-month /10-year Treasury yield inversion had little to no impact on credit spreads despite its track record as a reliable recession indicator. Tighter spreads, lower yields, and beta compression occurred simultaneously as the lower for longer, reach for yield, Fed/CB put mentality was in full force. The big drop in Treasury yields generated strong (total) returns of 2.44%, the strongest monthly (total) return since March 2016. The credit index yield of 3.55% was lower by 28 basis points (bps) on the month and is 54 bps lower since the start of the year. That reach for yield resulted in beta compression with BBB’s outperforming, including the recent M&A cohort of BBB’s that have lagged over the last year due to concerns over late stage re-leveraging.

Credit Index Spreads and Yields
Yields are 54 bps lower YTD while spreads are 29 bps tighter

Source: Bloomberg Barclays

March Total Returns for Various Fixed Income Classes

Source: Bloomberg Barclays

3-Month – 10-Year Treasury Curve Inverted in March

Source: Bloomberg Barclays

Returns and Flows Have Improved

Source: BofA Merrill Lynch Global Research, ICE Data Indices, LLC, EPFR Global

Index Performance

The credit index OAS of +113 bps over Treasuries was marginally tighter in March (-1 bps), bringing the YTD spread move to -30 bps. The reach for yield, beta compression theme continued as lower rated, higher yielding credits outperformed, including sectors that have recently engaged in leveraging M&A transactions – like tobacco and food and beverage. Two notable underperformers were CVS and Bayer. CVS spreads widened 7 bps in March (10yrs @ +168, 30yrs @ +218) on the heels of the Centene/Wellcare merger announcement. The concern specifically relates to Centene’s potential internalization of Wellcare’s PBM business which is currently contracted with CVS through 2020. While CVS does not disclose terms of its contract with Wellcare, the estimated EBITDA impact is $450 mln, or 2.6% of estimated 2019 CVS EBITDA. Bayer spreads widened 5 bps in March (and 50 wider since the Bayer/Monsanto merger closed) after a San Francisco jury awarded $80mm to a plaintiff in another Roundup trial. This is the second trial (both in California) where the jury decided in favor of the plaintiff though both cases are being appealed by Bayer. The standard for determining causation in a California jury trial is low which means that an appeal to a panel of judges is more likely to be decided based on the underlying science, which has not supported a connection between glyphosate use (the main ingredient in Roundup) and cancer. Most sell side estimates have the liabilities from Roundup at $5 - $6 bln, which assumes 15,000 cases at an average liability of $500,000 discounted back to today.

BBB/A Basis: The BBB vs. A basis is currently 67 bps, which was 4 bps tighter in March and 12 bps tighter YTD. The cycle range in the BBB/A basis is 30 bps at the tights to 169 bps at the wides (128 bp wides if we exclude 2009) so the relative value of the lower rated segment of the IG market, as a whole, is not compelling. At the same time, a record number (233 bln) of fallen A’s in 2018 widened 120 bps on average. That compares to 73 bps of widening for the entire BBB universe last year, highlighting the risk of paying up for ratings without properly assessing event risk.

March Index Returns

Source: Bloomberg Barclays

BBB vs. A Spread at 67 bps is Near the Cycle Mean

Source: Bloomberg Barclays

March Sector OAS Changes

Source: Barclays Capital

YTD Sector OAS Changes

Source: Barclays Capital

March 29, 2019 Sector OAS

Source: Barclays Capital

March Investment Grade Supply

March supply volumes were $121 bln, bringing the YTD total to $346.6 bln, down modestly (-2.8%) from the same period last year. M&A related supply was $21 bln in March, bringing the Ytd total to $53.4 bln. The largest M&A related deal in March came from AVGO (Broadcom), issuing $11 bln across 5 tranches to fund the CA acquisition (5yrs priced at +155, 10yrs @ +240). The current pipeline of pending M&A related bond issuance is $100 bln, which is relatively modest compared to the past four years – though that can certainly change if M&A activity picks up. The largest pending deals are BMY/CELO, Sprint/T-Mobile (deal probability low), and IBM/Red Hat.

Largest Pending M&A Deals With Potential Funding Needs

Note: We show Bloomberg’s calculation for deal probabilities: Bloomberg uses the deal terms and the current market price of the target company to calculate the deal probability that the market is pricing in: (current price less pre-offer price)/(target price less pre-offer price)]. Deal sizes are BofAML estimates based on public information.
Source: BofA Merrill Lynch Global Research, Bloomberg

Current Pipeline of M&A Deals (Total Enterprise Value)

Source: BofA Merrill Lynch Global Research

Monthly Supply Data

Source: BofA Merrill Lynch Global Research

YTD M&A Related Supply is Tracking Lower Than 2015, 2016 and 2018

Source: BofA Merrill Lynch Global Research, Bloomberg

 

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