August Credit Update

Monthly Commentary

September 02, 2016

Risk assets continued to push higher in August as stocks reached new highs and credit spreads tightened another 9 basis points to new year-to-date tights. Markets saw a continuation of the same theme – central bank induced yield repression driving investors into riskier assets. In credit, that has resulted in beta compression, as BBBs have outperformed As by 31 bps on the year (7 bps in August). Record August issuance did nothing to impede the rally as foreign demand continued unabated, driven by the “relative” cheapness of U.S. credit yielding 2.7%. The technical-driven rally has been monumental, yet the fundamental picture tells a different story – one of deteriorating credit metrics, depressed earnings and an erosion in pension funded ratios. One of the unintended consequences of the low rate environment has been the subsequent drop in the pension discount rate which has resulted in record pension deficits. As a result, the ratio of assets to liabilities (pension funding ratio) is estimated to be approximately 76.8%, down from 81% in 2015. Larger pension deficits will have a negative impact on earnings as pension expenses increase. Part of the pension expense comes from premiums paid to the PBGC (Pension Benefit Guarantee Corporation) to insure defined benefit plans. These fees, which are calculated as a percentage of the underfunded liability, have increased from 1.4% in 2014 to 3% in 2016, putting further pressure on corporations (and public pension plans) to fill the funding gap.

2Q Earnings recap:
2Q earnings for the S&P 500 came in at -.59% revenue growth and -4.1% eps growth. This marked the fifth straight quarter of negative eps growth and most consecutive quarters of negative growth outside of a recession. If we exclude energy, the picture looks a little better yet still rather anemic with eps growth of .8% on 3% revenue growth. With 2Q earnings in the rearview mirror, we can now reflect on income and balance sheet trends for the IG universe. Credit metrics continued to deteriorate, even for non-commodity sectors. Net leverage increased .44x to 2.41x (q2’16 vs q2’15), which is close to the all-time high in 2002. Energy experienced the largest y-o-y increase in net leverage due to a 38% decline in EBITDA. The only sector to show an improvement in leverage was domestic telecom, driven by de-levering at Verizon.

Credit Index Performance:
Spreads tightened 9 basis points in August, ending the month at an OAS of +129. Returns were a marginal .20% as the credit index yield remained relatively unchanged at 2.7% due to a modest rise in risk free rates. Beta compression continued as higher beta sectors outperformed, including energy, metals and sovereigns. The spread difference between BBB rated and single A rated securities is 70 basis points (ytd tights), 7 tighter on the month and 31 bps tighter on the year. The relationship, or basis, got as wide as 128 basis points in February. Best performing sectors were energy (-28 bps), sovereigns (-21 bps) and metals (-10 bps). Commodity price volatility continued with oil/WTI trading in an $8 range (20%) during the month. There was bullish sentiment around the prospect of an OPEC production freeze agreement at the next OPEC meeting (Sept 26-28). Then came the reality of a bearish EIA crude inventory report which showed U.S. stockpiles rose 2.28 mln barrels for the week ending 8/26. WTI price swings have been quite violent over the past several months, yet energy spreads have been resilient, despite the price volatility. Some of this resilience can be attributed to production rationalization and balance sheet remediation (via equity raises, dividend cuts etc). But overall, valuations seem to defy gravity, something that can be said about the credit markets as a whole.

Supply: Another supply record was broken in August as $112 billion worth of deals printed. In what is typically a slow month on the primary front, August issuance was the highest on record for this time of year. New issue concessions were de minimis as investors were just happy for the opportunity to buy some size. Supply was dominated by M&A related issuance and Yankee bank issuance. On the M&A side, the largest deal came from Microsoft, printing a $20 billion multi-tranched deal to fund the LinkedIn acquisition (10yrs priced at +90, 30yrs at +145). Vale printed a $1 billion 10 year at 6.25% (+470/10yr), a sign that EM issuance is starting to come back to life. Several Yankee banks tapped the market with subordinated issuance, including Barclays (sub debt 10yr @ +330), Stanln (sub debt 11yrs @ +280) and Socgen (sub debt 10yr at +275), to name a few.

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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. © 2017 TCW