April Credit Update

Monthly Commentary

May 08, 2019

The rally in credit spreads continued in April as the strong technical backdrop resumed, underpinned by strong overseas demand for IG credit, robust inflows into high grade funds and light dealer inventories. Macro headwinds and generally lackluster Q1 earnings reports did not derail the rally as Fed policy continued to be a driver of spread performance. The Q1 earnings bar had been adjusted low enough for companies to beat expectations. For the ~ 80% of the IG universe that has reported, earnings growth (YoY) is close to zero. FX headwinds and the absence of the one-time boost from last year’s tax cuts have been negatives. Additionally, margin compression continued to be a headwind as higher costs (labor, material, transportation) have eroded profits. In terms of the outlook, forward earnings guidance has generally been anemic, tracking at a ratio of 0.6x (above consensus forward guidance vs. below consensus).

Bank earnings were generally in line with expectations. Revenue growth remained weak (-3.3% for the big 6 U.S.) due to anemic loan growth (+1% YoY), lower investment banking revenues (-7% FICC YoY) and compressed net interest margins (+0% QoQ). From a bondholder perspective, capital and liquidity remain strong for the U.S. banks, which should help mitigate stress if/when the cycle turns. From a valuation standpoint, credit spreads (index OAS of +104) have experienced a full retracement of the Q4’18 widening and are approaching the post crisis tights touched in February of 2018. This argues for a yield capture vs. spread compression strategy as the risk/reward is skewed to the downside.

Credit Index OAS of +104 bps is Approaching the Cycle Tights Touched in Feb 2018

Source: Bloomberg Barclays

April Total Returns for Various Fixed Income Asset Classes

Source: Bloomberg Barclays

Q1 Earnings for IG Issuers

Note: 1Q-19 based on the actual results when available and consensus estimates otherwise
Source: BofA Merrill Lynch Global Research, FactSet

S&P 500 Management Guidance Ratio (# above vs. # below) of .6x Suggests Cautious Outlook

Source: Bloomberg, FactSet, Bank of America Merrill Lynch U.S. Equity & US Quant Strategy

Bond Fund Inflows Have Improved

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

Index Performance

The credit index OAS of +104 bps over Treasuries was 9 basis points tighter on the month, bringing the YTD spread move to -39 bps. Spread tightening and carry offset a moderate rise Treasury yields, resulting in monthly total return of 0.49% and bringing the YTD total return to 5.39%. The reach for yield/beta compression theme continued as the widest sectors outperformed. BBBs tightened 12 bps, causing the BBB/A basis to compress to 61 bps which is near the cycle mean. Best performing sectors were autos (-32 bps), led by Ford (-72) and GM (-36); Wirelines (-20 bps); life insurers (-16); independent energy (-15); and tobacco (-15). Auto spreads have undergone a meaningful recovery since the start of the year as sector sentiment improved and downgrade fears have moderated. Wireline outperformance was dominated by AT&T (-23 bps) and VZ (-19) on the heels of continued deleveraging progress. VZ tendered for $5 bln in long-dated bonds, bringing the company close to its leverage target (pre-2013 Vodafone wireless stake acquisition) of 1.75x-2.0x. Independent energy outperformance is the result of commodity price appreciation as well as M&A activity in the space. CVX (Chevron) and Oxy (Occidental Petroleum) are in a bidding war for APC (Anadarko Petroleum). At current trading levels of +145 bps over Treasuries (-60 bps in April) for 30-year APC bonds, that implies a roughly 60% probability of an OXY takeover. Underperforming sectors were healthcare and health insurers. Proposed changes to the healthcare system, the most radical of which is Senator Sanders Medicare-forall proposal, have weighed on spreads. From a practical standpoint, the high costs of the plan (estimated at $32 trillion over a ten-year period) would require massive taxation to foot the bill. In addition, a proposal to wipe out an entire health insurance industry would cause major disruption to our healthcare system and economy. As a result, this plan will face strong opposition and is unlikely to gain serious traction. More moderate proposals like an expansion of Medicare (lowering the eligibility age) would still be difficult to pass but would be far less destructive.

April Index Returns

Source: Bloomberg Barclays

April OAS Sector Changes

Source: Barclays Capital

YTD Sector OAS Changes

Source: Barclays Capital

April 2019 Sector Spreads

Source: Barclays Capital

April Investment Grade Supply

April IG supply volumes were $95.7 bln, bringing the YTD gross total to $442 bln, down 8% vs. the same period last year. M&A related supply was only $2.6 bln in April but is expected to accelerate given the increased backlog of debt funded deals (BMY/Celg, IBM/Red Hat, FIS/Worldpay). Given the strength in the overall market, new issue demand was strong and concessions were de minimis. The largest deal of the month came from Aramco, which issued $12 bln in debt across five tranches (5yrs priced @ +75, 10yrs @ +105, 30yrs @ +155). This was the debut debt issuance for Saudi Arabia’s state-owned energy company, and while the credit is inextricably linked to its parent, it priced 10 basis points through the sovereign.

Monthly IG Supply

Source: BofA Merrill Lynch Global Research

Supply Related to M&A

Source: BofA Merrill Lynch Global Research

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

Source: BofA Merrill Lynch Global Research

Large Pending M&A Deals With Potential Funding Needs

Note that 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). This approach breaks down when either 1) the current price is below the offer price as would imply a negative deal probability (like T-Mobile vs. Sprint right now), or 2) when the current price exceeds the target price which would imply a deal probability exceeding 100% (as is the case in the multiple-offer situation for Anadarko right now).
Source: BofA Merrill Lynch Global Research, Bloomberg

 

 

 

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