August Credit Update

Monthly Commentary

September 12, 2018

Credit spreads were only modestly wider in August despite compounding idiosyncratic risks in EM, European weakness (notably Italy) and the possibility of new trade tariffs. While IG European and EM-related credits experienced some divergence vs. U.S. domiciled credits, the underperformance has thus far been limited in scope. The spillover from the multitude of “idiosyncratic” risks – ie Turkey, Argentina, Brazil, South Africa – has thus far been reasonably contained. It does beg the question, how long can these risks remain isolated in the face of an aging cycle and tightening global liquidity? Shrinking central bank balance sheets and tighter liquidity conditions have been a source of volatility in the credit markets. The forces that propped up the market and triggered consecutive years of QE-led spread tightening have also masked vulnerabilities, including peak levels of corporate leverage and the massive growth in the credit markets. While tax cuts and repatriation have boosted earnings (by an estimated 40%) and cash flow, we have not seen that translate into better corporate balance sheets due to record M&A and share buybacks. In fact, credit metrics deteriorated in Q2, with net leverage increasing .14x for the IG non-fin credit universe. Additionally, interest costs have increased, resulting in coupons on newly issued debt exceeding maturing debt for the first time since 2009.

How Many Idiosyncratics Elements Will it Take to Make it Systemic?

Source: Bloomberg, Credit Suisse

Net interest costs are rising. YTD the average coupon on newly issued debt is exceeding the average coupon on maturing debt by 23 bps.

Source: J.P. Morgan

Credit Metrics Not Improving Despite Earnings Growth and Tax Cuts

Source: J.P. Morgan

2Q18 Net Leverage Changes by Sector

Source: J.P. Morgan

YTD Returns for Various Asset Classes. EM has Underperformed, U.S. HY has Outperformed

Source: Barclays

Index Performance: August was generally a weak month for credit as growing macro concerns outweighed generally supportive technicals (light dealer balance sheets, light new issue calendar). Credit spreads widened 5 basis points, ending the month at an OAS of +108 basis points over Treasuries. Returns were positive (+.51%) on the month due to lower Treasury yields offsetting wider spreads. The year-to-date return on the credit index improved somewhat to -1.79% from -2.29% the prior month. In terms of sector performance, higher beta marginally underperformed with BBBs +6 bps on the month vs. As +3 bps and AAs only 1 wider. YTD, the relationship between higher rated (single A) and lower rated (BBB) credits has been comparable. The decompression that typically occurs during periods of spread widening has not materialized, in part due to re-leveraging actions in several high quality sectors such as rails and diversified manufacturing. Year–to-date, AAs are 9 bps wider, As 19 bps wider, and the BBB segment of the market is 23 bps wider. In August, the higher beta underperformance was led by autos (+14 bps), metals (+11), tobacco (+11) and independent E&Ps (+9). Outperformers on the month were REITs (-3 bps), banks (+2), munis (+2) and utilities (+3). Taxable muni’s continue to be the best performing sector with spreads only marginally wider (+2 bps) on the year.

August Credit Index Returns

Source: Bloomberg Barclays

Monthly Excess and Total Returns

Source: Barclays Capital

Mtd and Ytd Sector OAS Changes

Source: Barclays Capital

August Investment Grade Supply: IG supply volumes were $92.5 bln in August, a 38% increase vs. July. Industrial supply totaled $58.5 bln, including $17 bln in M&A-related financing. The largest deal came from UTX, issuing $11 bln across six maturities to fund the acquisition of Rockwell Collins. The 5yrs priced @ +90, 10yrs @ +125, 30yrs @ +160. The deal came with a 10 basis point concession, after having already widened 50 basis points on the year. The acquisition was a leveraging transaction that resulted in a one-notch downgrade by both Moody’s and S&P, causing $20 bln of index eligible debt to fall out of the single A index. UTX is the largest issuer YTD to lose its single A rating. Others include UNP ($12 bln of index eligible debt), Monsanto ($4.8 bln), Starbucks ($5.2 bln) and PCG ($4.3 bln). All of the downgrades with the exception of PCG were a consequence of re-leveraging events, either M&A (in the case of UTX) or share buybacks (UNP and SBUX). The PCG downgrade (to Baa1) was related to the California fires and potential liabilities stemming from the state’s application of inverse condemnation to privately owned utilities – which essentially puts CA utilities on the hook for fire damages regardless of causation. Somewhat mitigating this risk, SB901 was recently passed, which allows for the potential recovery (via securitization) of wildfire-related costs – subject to CPUC discretion and interpretation.

Monthly New Issue Volumes

Source: BofA Merrill Lynch Global Research

M&A-Related New Issue Volumes

Source: BofA Merrill Lynch Global Research

Enterprise Value of Pending M&A Transactions With Issuance Implications

Source: BofA Merrill Lynch Global Research


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