June Credit Update

Monthly Commentary

July 09, 2018

Investment Grade credit ended the 1H18 on a weak note. Rising rates, a strong dollar, EM weakness, trade tensions and the releveraging of corporate balance sheets continued to weigh on spreads. At an OAS of +116 as of June 29, credit spreads have experienced meaningful widening since touching the post crisis tights of +81 in February ’18 while YTD total returns of -2.99% are the worst since 2013. The underperformance of IG credit vs. other asset classes, especially HY, is notable (see chart below). The resurgence of debt-funded M&A activity at a time when overseas buying has tapered and inflows into ETFs and mutual funds have decelerated, is putting additional pressure on the supply/demand imbalance. Tax cuts and earnings repatriation have provoked “animal spirits,” resulting in record North American M&A volumes ($670 bln YTD) and share buyback volumes ($155 bln thru Q1). The M&A frenzy has produced some eye popping acquisition valuations. Recent transactions in the food and beverage sector traded close to 20x EV/EBITDA multiples, including CPB’s acquisition of Snyder at a 20x multiple, GIS’s purchase of Blue Buffalo at 25x, Keurig’s purchase of DPS at 16x and Bacardi’s acquisition of Patron at 19x. Event risk has not been limited to food and beverage. Cable is the worst performing sector YTD (+56 bps) as Comcast and Disney are currently engaged in a bidding war for the Fox assets (last bid at 15x EV/EBITDA). The transaction, whomever the victor, will likely result in a meaningful rise in leverage and a significant amount of debt issuance. Emblematic of this part of the credit cycle, the majority of M&A transactions have been debt funded, leveraging transactions. As a consequence, the ratings quality of the credit universe has deteriorated, with BBB’s now accounting for 44.06% of the index, even as credit rating downgrades have been limited and issuers given the benefit of aggressive post deal de-leveraging promises.

YTD Returns by Asset Class

Source: Barclays Capital

Quality of Bloomberg Barclays Credit Index, 1973-2018

Source:Bloomberg Barclays Indices, Barclays Research

Historical 1st Half Returns

Source: Barclays Capital

Historical Annual Returns

Source: Barclays Capital

Index Performance: The credit index OAS of +116 basis points over Treasuries was 7 basis points wider in June. Marginally higher Treasury yields coupled with wider spreads produced negative excess (-.49%) and total (-.47%) returns. Duration underperformed, beta did not: Flatter Treasury curves (2-30s @ 46 bps as of 6/29) continued to pressure credit curves. Sectors with longer average durations have generally underperformed YTD. A good example is the utility sector, which has an average duration of 9.73 years vs. 7.01 years for the overall index. Despite being a sector that has historically exhibited lower beta vs. the overall market, it has experienced similar widening vs. the broader credit index YTD. Beta has not underperformed: The typical decompression trade that is witnessed during bouts of volatility has not transpired. Credit quality/ratings have not been a determinant of spread performance YTD as BBBs are outperforming As. High quality has not been much of a safe haven as M&A and/or share buyback-related releveraging in sectors like rails (UNP) and cable (CMCSA) have similarly impacted both higher rated (A) and lower rated (BBB) credits/sectors.

June Credit Index Returns

Source: Bloomberg Barclays

Sector OAS Changes – Sorted by MTD Best to Worst

Source: Barclays Capital

Sector OAS Changes – Sorted by YTD Best to Worst

Source: Barclays Capital

June Investment Grade Supply: IG Supply for the month totaled $119.4 bln, a new June record. Industrial supply of $80 bln was again dominated by M&A-related issuance ($33 bln). The largest deals came from Bayer (for Monsanto acquisition, $15 bln across five maturities, 5yrs priced @ +115, 10yrs @ +155, 30yrs @ +185) and Walmart (for Flipkart acquisition, $16 bln across seven maturities, 5yrs priced at +60, 10yrs at +80, 30yrs at +105). New issue performance, while mixed (about 50/50 wider/tighter) was an improvement vs. the prior two months as concessions were larger (+7 bps on average) and relative value was more compelling. Take Walmart (WMT) for example. At +105/OLB, the 30yr priced with a 10 bp concession after having already widened 40 bps YTD and 50 bps vs. the February tights (yes, that is 2x spread widening). Compare that to the overall long credit index which is 35 bps wider YTD and is lower quality, with an average rating of A3/BBB+ vs. AA for WMT.

Monthly Supply Volumes

Source: BofA Merrill Lynch Global Research

 

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