August Credit Update

Monthly Commentary

September 10, 2019

August was a rough month for risk assets as a new round of trade tariffs took effect on September 1. While the protracted trade war was the main catalyst for market volatility, idiosyncratic risks emanating from the U.K. (Brexit) and Argentina (bonds in the $30’s, capital controls) put further pressure on an already tenuous market. The macro weakness and increased recession risk led to an inversion of U.S. 2yr/10yr Treasury yields for the first time since before the financial crisis (2007). Credit continues to be vulnerable to a changing cycle after years of fundamental erosion via re-leveraging transactions. As we know, that has not been the driver of spread performance YTD. The driver has been the central bank-led risk grab from yield-starved investors in the wake of dropping global yields and $17 trillion of negative yielding debt. However, it was the macro that drove spreads wider in August as the market digested the implications of a prolonged trade war on economic growth and an increased probability of a hard Brexit. The credit index OAS of +114 basis points (bps) over Treasuries was 11 bps wider in August, resulting in a monthly excess return of -0.92%. While spreads widened, returns were strong (+3.13% on the month) as yields dropped 35 bps to 2.74% (compared to cycle lows of 2.46% in May 2013). Year-to-date, the total return of the credit index is 13.35%, its strongest annual return since 2009.

Credit Index Yields Fell 35 bps While Spreads Widened 11 bps

Source: Bloomberg Barclays

August Total Returns for Various Fixed Income Asset Classes

Source: Bloomberg

US 2/10’s Yield Curve (bps) and Recessions

Source: Deutsche Bank, Bloomberg Finance LP, GFD, NBER

U.S. Tariffs on Chinese Imports

Source: BofA Merrill Lynch Global Research, Census Bureau, USTR
Note: Estimated coverage and tax are based on import data from the Census Bureau for 2018 and the product lists published by the USTR.

Yield Grab:

Source: Bloomberg

Volatility Spiked in August (Intraday Vol)

Source: Barclays

Tariffs by Bucket

Source: BofA Merrill Lynch Global Research

Index Performance

Global growth risks and the escalating U.S.-China trade war against the backdrop of lingering late cycle fears and relatively stretched valuations led to a big reversal in risk sentiment. The 11 bp move wider in spreads reversed all of July’s move tighter (and then some), though lower Treasury yields produced positive total returns of 3.13% on the month and 13.35% YTD. Spread performance was generally weak across the board though we saw some decompression with BBBs underperforming, led by cyclical sectors like oil field services (+32 bps), independent energy (+23 bps), midstream energy (+23 bps), refiners (+21 bps) and metals (+21 bps). While energy prices (WTI and natural gas) recovered in the latter part of August, spreads did not as the intra month price volatility underscored fears of an economic slowdown and/or recession and its potential impact on demand. Best performing sectors were munis (+3 bps) and consumer products (+5 bps), both lower beta, higher rated/quality sectors. Year-to-date, autos (-46 bps) and banks (-43 bps) are the two best performing sectors. Banks, domestic banks in particular, are viewed as a safe place to hide in the face of continued re-leveraging and ratings degradation within the industrial sectors. Moreover, issuance out of the banking sector has been modest as banks have generally fulfilled their TLAC (total loss absorbing capacity) requirements. Auto spread remediation has occurred on the heels of better than feared auto sales (SAAR) and some progress on the cost restructuring side.

August Index Returns

Source: Bloomberg Barclays

U.S. Monthly Auto SAAR, Last Two Years

Source: TCW

August Sector OAS Changes

Source: Barclays Capital

YTD Sector OAS Changes

Source: Barclays Capital

August Investment Grade Supply

August Investment Grade Supply: August supply volumes of $84 bln were dominated by industrial issuance of $66.5 bln vs. only $17.6 bln from financials. Thematically, the de-leveraging of the banking system and the re-leveraging of industrial issuers has resulted in a divergence in issuance and spread performance between the two sectors. Industrial issuance has outpaced financials in a material way since the crisis, which helps explain the relative outperformance of financials over the cycle. We are also seeing an increase in longer dated issuance as lower rates/yields compel companies to borrow long term. The share of 10yr and longer debt issuance has risen to 63% Ytd compared to the 54% average since 2010. M&A related supply in August totaled $22 bln. The largest deal came from Oxy, issuing $13 bln across seven maturities to fund the Anadarko acquisition; 10yrs priced @ +185, 30yrs @ +225. This was the first large M&A transaction in the E&P sector in several years. We have seen smaller deals across the sector, including several private equity transactions in the midstream space (BPL, ENLK, Rockies for example). The absence of change of control language in the midstream space makes bondholders more vulnerable to LBO transactions. Change of control provisions are quite common among industrial issuers that are considered susceptible to leveraged buyouts. An estimated 45% of industrial issuers have COC language. Investors should demand the same from midstream issuers.

IG Monthly Supply

Source: BofA Merrill Lynch Global Research

M&A Related Supply (High Grade $bn)

Source: BofA Merrill Lynch Global Research

Share of Financial Supply

Source: BofA Merrill Lynch Global Research

Maturity Distribution of Supply

Source: BofA Merrill Lynch Global Research

Reverse Yankee Issuance:

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