May Credit Update

Monthly Commentary

June 07, 2017

Risk assets remained resilient in May with equities reaching new peaks, volatility new lows and credit spreads near the cycle tights. Demand for spread product outweighed record investment grade supply as foreign and domestic inflows into IG funds continued. Investment grade credit spreads tightened another 3 basis points in May, ending the month at an OAS of +107 basis points over Treasuries. Spreads are now just 14 basis points off the cycle tights of +93 touched on June 2014. The market for risk assets remained constructive despite the lack of progress on tax and healthcare reform. Policy uncertainty and generally lackluster economic data (GDP, auto sales, retail sales) have been overshadowed by strong Q1 earnings growth, which for the investment grade universe was 14% on a year-over-year basis. Commodity related sectors showed the largest y-o-y improvement given the weak comps, but even excluding energy, growth was strong at 9.8%. The weakest sectors were transportation and autos. In transportation, airline growth was down y-o-y due to very tough comps as 2016 saw record revenue and traffic for the industry. Auto earnings were mixed with GM outperforming due to strength in SUV sales. Overall, incentives have been increasing - putting pressure on the bottom line - while sales have come down from record levels. The SAAR (seasonally adjusted annual rate) for light vehicles sales in May came in weaker than expected at 16.58 million vs. estimates of 16.8 million. That is down from the cycle peak of 18.4 million reached in Dec ’16. Despite three consecutive quarters of solid earnings growth for the IG universe, credit metrics did not improve as debt grew more than EBITDA. With net debt/EBITDA at 2.44x at the end of Q1’17, leverage remains at/near all-time highs as easy monetary policies have fueled debt funded M&A and share buybacks.

Q1’17 Earnings for IG Issuers

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

Q1’17 Earnings for IG Issuers by Sector

Source: BofA Merrill Lynch Global Research

Cumulative Mutual Fund Flows. 2017 Exceeding Prior Years

Note: Flows prior to 2012 are from AMG, flows for year 2012 are from EPFR.
Source: BofA Merrill Lynch Global Research, Lipper/AMG, EPFR

U.S. Light Vehicle SAAR vs. Y-o-Y Incentive Growth

Source: Autodata, Goldman Sachs Global Investment Research

YTD Fund Flows

Source: BofA Merrill Lynch Global Research

Despite Good Q1 Earnings Growth, Net Debt Grew More Than LTM EBITDA

Source: BofA Merrill Lynch Global Research

As A Result, Credit Metrics Continued to Deteriorate

Source: JP Morgan

Spread compensation per turn of leverage is 67 basis points, tighter than last cycle’s tights of 69 bps in 2006

IG Spread per Unit of Leverage

Index Performance: The investment grade credit index tightened 3 basis points in May, ending the month at an OAS +107 basis points. The index yield of 3.06% was 8 basis points lower on the month as spreads and Treasury yields rallied. The best performing sectors were cable (-8 bps), midstream (-7), paper (-7), wirelines (-6), refiners (-6) and pharma (-5). For midstream, the fact that tightening in the sector occurred in the face of commodity price volatility is notable. An oil price rally failed to materialize despite the OPEC output cut extension, as increased U.S. shale production will offset much of those cuts. U.S. crude production of 9.3 million barrels per day is nearing peak 2015 levels. The midstream sector has outperformed the E&P sector year-to-date and both sectors (independent E&P and midstream) are now trading at similar spreads (OAS of 162 vs. 165). The midstream sector as a whole has remediated as companies have rationalized balance sheets via equity raises, capex and distribution cuts. The best performers include CQP (-59 bps YTD) and WPZ (-46 bps YTD) - both midstream credits that have meaningfully de-risked. WPZ sold its petrochemical plant for $2.1 bln, thereby reducing direct commodity exposure and de-levering using the proceeds. CQP owns and operates gas liquefaction facilities in Louisiana with a total current export capacity of 2.6 Bcf/d. Debt is at the project/operating company level and is supported by long term take-or-pay contracts with high quality off-takers. Trains 1-4 are operational and train 5 is 63% complete, thus construction risk has greatly diminished. Additionally, the company has de-levered by refinancing debt at the operating company/project level with debt at the parent/ holding company. As a result, CQP was recently upgraded to investment grade by all three rating agencies.

The bid for 30 year corporates helped drive wireline and cable spreads tighter as those sectors have the steepest credit curves. The wireline/wireless sector is one of the widest sectors in the credit index and has been one of the worst performers year to date as continued M&A related issuance has pressured those issuers with already very large capital structures (and thus large index weightings). For pharma/healthcare, a decrease in debt issuance has positively impacted spreads as M&A has been significantly lower vs. last year. While we have seen a pickup in activity recently with two large deals funding in May (BDX $9.6 bln debt issuance and CAH $5 bln), year-to-date healthcare M&A-related issuance is $9.7 bln, a 45% drop vs. 2016 (Jan – May).

May Credit Index Returns

Source: Bloomberg Barclays

10-30’s Telecom Spread Curves Have Flattened But Still Steep at ~54 bps

Source: BofA Merrill Lynch Global Research

10-30’s Industrial Spread Curve Flatter. More in Line With Historical Averages.

Source: BofA Merrill Lynch Global Research

May Investment Grade Supply: New issue volumes jumped to $161 bln in May, the third largest supply month on record. M&A-related issuance climbed to $33 bln after averaging just $6 bln a month through April. Some of the larger M&A-related deals included BDX ($9.675 bln multi-tranched deal to fund BCR acquisition, 10yr priced at +145), QCOM ($11 bln to fund NXPI acquisition, 10yr priced at +105), and SHW ($6 bln to fund Valspar acquisition, 10yrs priced at +120). Demand was strong and most deals were several times oversubscribed, though new issue performance was mixed. As has been the case for most of this year, initial price talk is whispered with 10-15 basis points of concession but then ultimately prices with zero. We also saw several deals price with negative concessions. In the energy space, two high quality names came to market (WPZ and TCP) and priced through existing bonds. That in turn caused secondary spreads to tighten not only for those two names but for the sector as a whole. Another interesting development is the increase in floating rate issuance, which was $29 bln in May, the highest since the crisis. The demand for floaters has increased as investors look to hedge against rising interest rates. Moreover, with 3 month LIBOR having risen to 1.22%, the gap between the yield of a fixed vs. a floating rate note has compressed.

Monthly IG Issuance

Source: BofA Merrill Lynch Global Research

M&A- Related Issuance

Source: BofA Merrill Lynch Global Research

New Issue Concessions

Source: BofA Merrill Lynch Global Research

Breakdown of M&A-Related Supply by Sector

Source: BofA Merrill Lynch Global Research

Floating Rate Supply on the Rise

Source: BofA Merrill Lynch Global Research

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