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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