July Credit Update

Monthly Commentary

August 02, 2016

The quest for yield pushed risk assets higher in July. Stocks (S&P 500) touched new highs and credit spreads tightened 9 bps to new YTD tights. Fundamentals continue to take a back seat as the global scarcity of investment yields continued to drive risk assets higher/tighter. With around 31% of global government yields in negative territory and European corporates yielding 66 basis points, U.S. credit, yielding 2.67%, looks attractive by comparison – or so the story goes. Never mind that earnings have been rather weak, with the S&P 500 headed for its fifth consecutive quarter of negative EPS growth. Forget the fact that credit metrics have deteriorated as corporations have increased leverage on cheap borrowed money. Technicals have trumped fundamentals as global central bank easing and the subsequent increase in the pool of negative yielding assets has pushed investors into risk assets. The value proposition dilemma for credit has become more acute as inflows into U.S. fixed income by both foreign and domestic buyers have been strong.

2Q Earnings: As of July 29, 63% of the companies in the S&P 500 have reported second quarter earnings. For the 314 companies that have reported so far, EPS growth is -3.7% year-over-year. While this is an improvement vs. the past three quarters, it is the fifth straight quarter of negative EPS growth, the most consecutive quarters of negative growth outside of a recession. If we exclude energy and financials, EPS growth is still anemic at 1.3%. From a sector standpoint, energy has been hardest hit at -85% year-over-year EPS contraction. Sectors showing the strongest EPS growth are consumer discretionary, led by autos +21% and internet retailers +300% (NFLX and AMZN).

Bank earnings were generally better than expected for the U.S. money centers. Earnings growth remains challenged as the low interest environment pressures margins. FICC revenues rebounded off of weak year-over-year comparisons (up 18% on average) though equity trading and investment banking showed declines. NIM compression continued, down 6 bps on average to 2.55% for the big 4 (BAC, JPM, C , WFC). Efficiency ratios were in the high 50% range as cost controls and headcount reductions continued. From a capital standpoint, CET1 ratios improved 20 bps on average, with the big 6 all well above 10%.

M&A: Several M&A announcements in July, including: Verizon’s purchase of Yahoo’s core businesses for $4.83 billion in cash. Leverage impact is minimal at 0.1x. ADI is acquiring Linear Technology for $14.8 billion, including $7.3 billion of new debt to be issued. Ratings were subsequently downgraded one and two notches to (Baa1/BBB) as leverage goes up more than 2x to 4x. Also Nextera is acquiring an 80% stake in Oncor Electric for $14.7 billion, a 28x 2015 P/E ratio. This is a credit positive for Oncor bondholders as ownership moves from financial investors to a highly rated strategic owner. Ratings on Oncor first mortgage bonds were upgraded one notch to A3 at Moody’s and left on upgrade watch.

Deal Risk: The two M&A deals that seem to be at risk are AET/HUM and ANTM/CI as the Department of Justice filed a lawsuit to block both mergers, citing anti-competitive concerns. Both Aetna and Anthem plan on challenging the suit. Aetna issued bonds in June to fund the HUM acquisition. The majority of $13 billion of bonds issued have a mandatory $101 redemption feature if the deal falls apart. Mandatory redemption language has been a common component of recently issued M&A related bond deals. Given the challenging regulatory environment from both an antitrust and tax inversion standpoint (recall PFE/AGN), it will be interesting to see if investors demand more concessions for deal call risk going forward.

Global Benchmark Yields

Source: Barclays

S&P 500 EPS and Revenue Growth

Source: Bloomberg

Q2 Earnings Summary

Source: BofA Merrill Lynch Global Research

Source: BofA Merrill Lynch Global Research

S&P 500 Dividend Yields vs. IG industrial Bond Yields. Relationship at historical tights which could further encourage companies to issue debt for shareholder returns.

S&P 500 Dividend Yields vs. IG industrial Bond Yields

Source: Barclays

Credit Index Performance: Spreads tightened 9 basis points in July, ending the month at an OAS of +138. Returns were strong at 1.31% as both spreads and Treasury rates rallied. The index yield of 2.67% is approaching the cycle lows of 2.46% set in May 2013. The best performing sector in July was metals (+2.63% excess return) with the gold and iron ore names outperforming as prices rallied. Financials and Industrials were the best of the broad sectors, tightening 11 basis points each. Within financials, European banks outperformed after underperforming for most of this year. UK bank spreads recovered meaningfully from their post Brexit selloff with BACR -36 bps on the month and Lloyds -33. The worst performing sectors and the only sectors to post negative excess returns in July were independent energy, oil field servicers and sovereigns. The energy spread rally came to a screeching halt towards the end of the at month as oil prices approached $40, down $8 in July. Energy spreads were still 5 basis points tighter on the month as MLPs (-14 bps) and integrateds (-3) outperformed independent E&Ps (+5) and servicers (+9). YTD, energy spreads are still significantly tighter at -67 bps. Sovereign spreads widened 2 basis points on the month though performance was bifurcated. Turkey, which has the largest weighting in the sovereign sector, widened 43 bps on the heels of the coup. The other names to underperform were those most correlated to oil – like Mexico and Columbia.

July Credit Index Returns

Energy Spreads vs. Oil (Inverted)

Source: Barclays Live

Supply: New issue volumes were $96 billion in July. Investors required little to no new issue concessions as demand was strong and most deals were several times oversubscribed. M&A related supply totaled $20 billion with the largest deal coming from TEVA to fund the acquisition of Allergan’s generic business ($15 bln across 6 tranches, 10 yr priced at +160, 30 yr at +185). Other large deals included: Verizon, with a $6.15 billion multi-tranched deal (10 yr priced at +115, 30 yr at +190) and AAPL, printing its third U.S. dollar deal this year ($7 billion multi-tranched deal, 10 yrs priced at +98, 30 yr at +163).

IG Monthly Supply Volumes

Source: BofA Merrill Lynch Global Research

New Issue Concessions

Source: BofA Merrill Lynch Global Research

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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