April Credit Update

Monthly Commentary

May 04, 2018

April was another lackluster month for credit as higher rates, inflation concerns and increased event (M&A) risk outweighed generally sanguine earnings reports. Earnings have thus far been strong with the investment grade corporate universe posting a 19.5% YoY growth rate for Q1’18. Yet despite what appears to be a robust earnings season, commentary from bellwethers like CAT about having reached the “high water mark for the year,” caused the market to question forward looking expectations. For credit investors, the transition to global quantitative tightening nine years into the cycle has been an additional source of volatility. Consecutive years of spread tightening on the heels of the QE-led reach-for-yield has masked vulnerabilities, including peak levels of leverage and the massive growth in the credit markets. The resurgence of (debt funded) M&A activity is putting additional pressure on the supply/demand imbalance. Investment grade new issuance of $123.5 billion set a new April record and the forward calendar is expected to be heavy as M&A-related issuance accelerates. Demand for credit has softened as inflows into ETFs and mutual funds have decelerated (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. The flattening of the Treasury curve is also starting to negatively impact the bid for duration, causing credit curves to steepen as the long end underperforms.

Credit Index Yields and Spreads:

Index yield of 3.84% at seven-year highs. Spreads much closer to the tights.

Source: Bloomberg Barclays

Q1’18 Earnings Growth for the Investment Grade Universe Up 19.5% YoY

Note: 1Q17 based on the actual results when available and consensus estimates otherwise
Source: BofA Merrill Lynch Global Research, FactSet.

Q1 Earnings by Sector

*Based on actual and estimates
Source: BofA Merrill Lynch Global Research, FactSet.

M&A Volumes (Thru 4/30) Accelerating

Source: Credit Suisse, Bloomberg

Source: Credit Suisse, FactSet

Source: Credit Suisse, Bloomberg

Index Performance: The Credit Index OAS of +102 basis points over Treasuries was 1 bp tighter in April, resulting in a positive excess return of .02%. Higher Treasury yields negatively impacted returns which were -.93% on the month, bringing the YTD return to -3.02%. To put that in perspective, the last time returns were this negative was in 2008 (-3.07%). Moreover, annual returns have only been negative three (’08, ’13, ’15) out of the last ten years. In terms of sector performance, sovereigns underperformed (+6), driven by currency weakness across EM. The best performing sector was energy (-4), led by refiners (-7 bps) as oil/WTI ended the month at $68.57 (up $3.63). Outside of energy, the decompression trade continued with higher quality AA/A (-3, -2 bps) outperforming BBB’s (+2 bps). While the BBB vs. A differential has widened from the cycle tights (currently 51 bps vs 43 in February), it is still tight of historical averages. The degradation in credit quality of the index is noteworthy. The cohort of BBB credits has grown to 43.62%, up 11.5% since the start of the cycle. Record debt growth has far outpaced ebitda growth, resulting in record levels of leverage for the IG universe. 14% of the nonfinancial corporate universe is now levered more than 5x and 23% is levered more than 4x. With the amount of highly levered companies doubling over the past five years, the margin for error if/when the cycle turns is quite thin.

April Credit Index Returns

Source: Bloomberg Barclays

Monthly Index Returns

Source: BofA Merrill Lynch Global Research

BBB’s have grown 11.5% over the last decade

Quality Analysis of Barclays Credit Index, 1973-2018

Source: Bloomberg Barclays Indices, Barclays Research

14% of the non-financial corporate universe is levered more than 5x and 23% is levered more than 4x on a gross basis

Source: Capital IQ and J.P. Morgan, as of 4Q17.
Data based on the Non-Financial companies in J.P. Morgan’s HG bond index.

Decompression. BBB’s Have Started to Underperform

Source: Bloomberg Barclays

April Investment Grade Supply: It was another heavy month in primary issuance with $123.5 billion pricing in April. Supply was evenly split between financials ($61 bln) and non-financials ($63 bln) as bank supply picked up post-Q1 earnings releases. Banks that issued included JPM (issued $8 bln across five tranches, 11nc10 priced @ +118), Citi (issued $5.5 bln across three tranches, 11nc10 priced @ +125/10yr) and Goldman ($5 bln in two tranches, 11n10 priced @ +135/10yr). M&A related issuance was $17 bln in April, led by GIS which issued $6.05 bln across six maturities (10yr priced at +145, 30yr @ +170) to fund the Blue Buffalo acquisition. Acquisition-related supply is expected to accelerate over the coming months as the backlog of M&A grows. Large pending deals include ESRX/CI (~ $22 bln debt funded), Monsanto/Bayer ($20 bln), DPS/Keurig ($12.5 bln) and UTX/COL ($10 bln).

EV of Pending M&A Transactions With Expected IG Issuance

Source: BofA Merrill Lynch Global Research

Monthly IG Issuance

Source: BofA Merrill Lynch Global Research


Media Attachments

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW