Technical vs. Fundamental Divergence

Credit Update

October 04, 2019

In the tug of war between the QE-led reach for yield and fundamental weakness, technicals got the upper hand in September as the Fed delivered another rate cut and the ECB restarted QE. It was an eventful month as market risks mounted – weak global economic data, trade wars, Brexit, impeachment, Hong Kong protests, Saudi oil facility bombings and repo market funding stress. The spike in short term secured funding rates was generally viewed by the markets as technical in nature (T-bill issuance, quarter end funding needs) though in our view it underscores the structural pressures on dollar liquidity resulting from Fed QT and bank capital buffer constraints. There appears to be no easy solution. The easing of capital requirements for banks might alleviate some funding pressures but poses systemic risk (we need better capitalized banks this late in the cycle) while another round of Fed QE could further drive up asset prices/bubbles.

While the macro risks, combined with deteriorating credit fundamentals, stretched valuations, massive growth in the credit markets, worsening liquidity conditions and rising idiosyncratic risks are warning signs of the troubles that lie ahead, the central bank put was the overriding factor for risk asset performance this month. The ECB announced a resumption of its asset purchase program at Euro 20 bln per month starting in November with no set end date. While no explicit details on the composition of bond purchases were given, expectations are for it to resemble previous QE exercises. That implies ~ 10-12% of purchases (or ~ 2 bln euros/month) will be designated for the Corporate Sector Purchase Program.

Accommodative central bank policies kept spreads in check and the appetite for risk assets intact in September. On the demand side, inflows into IG credit remained robust (near record YTD inflows) as the market digested heavy new issue volumes. Attractive funding costs encouraged issuers to borrow record amounts of long term debt. Five issuers priced 30yr bonds with two handle coupons, including Disney, which issued a 30yr at 2.75%, the lowest 30yr coupon on record.

The Whipsaw Continued:

Source: Bloomberg Barclays

Yield Scarcity:

Source: Bloomberg Barclays

QE: Central Bank Holdings by Asset Class

Source: Deutsche Bank, ECB, BoE, Fed, BoJ, Bloomberg Finance LP, SIFMA

Short Term Funding Stress:

Source: Bloomberg

Index Performance

After 11 bps of widening in August, IG credit spreads posted a partial recovery in September as the QE- led technicals outweighed a weakening fundamental backdrop. The reach-for-yield theme remained intact as higher beta outperformed with a few exceptions. The credit index OAS of +109 bps over Treasuries tightened 5 bps on the month as BBBs (-6 bps) and cyclicals outperformed. Tighter spreads produced positive excess returns of .38% on the month while higher risk free rates resulted in negative total returns of -.65%. YTD returns remain strong at 3.75% (excess returns) and 12.61% (total returns). The best performing sectors in September were some of the worst performers in August as commodity-related names reversed much of last month’s widening. This cyclical cohort was comprised of oil field servicers (-20 bps), metals and mining (-12 bps), refiners (-10 bps) and independent energy (-9 bps). The remaining outperforming sectors included diversified manufacturing (-15 bps) led by GE (-45 bps), supermarkets (-11 bps), tech (-9 bps) led by BBB names, and media (-9 bps). GE bonds rallied as the company made further deleveraging progress from more asset sale realizations and a subsequent $5 bln bond tender announcement. The worst performing sector in September was tobacco (+8 bps), driven by MO (Altria) after PM/MO merger talks ended. Other underperformers included sovereigns (+1), autos (-2 bps) driven by an ongoing UAW strike at GM, and health insurers (-3 bps). Healthcare related sectors have generally underperformed YTD as proposed changes to the healthcare system have weighed on spreads. The most radical of the proposals is Medicare for all, which is supported by both Senators Warren and Sanders. From a practical standpoint, the high costs of the plan (estimated at $32 trillion over a 10-year period) would require massive taxation to foot the bill. In addition, a proposal to wipe out an entire health insurance industry would cause major disruption to our healthcare system and economy. As a result, this plan will likely face strong opposition. More moderate proposals like an expansion of Medicare (lowering the eligibility age) would still be difficult to pass but would not be as destructive.

September Index Returns

Source: Bloomberg Barclays

Monthly OAS Changes

Source: Barclays Capital

YTD OAS Changes and Sector Spreads

Source: Barclays Capital

September Supply

September gross supply volumes of $166 bln were the third largest on record as issuers took advantage of the rally in corporate bond yields. Five issuers priced 30yr bonds with 2 handle coupons, including Disney, which issued a 30yr at 2.75%, the lowest 30yr coupon on record. About two-thirds of new issue proceeds in September were used to refinance maturing debt and/or term out front end debt. As such, the percentage of long dated issuance (10yr and 30yr) climbed to 70% in September, compared to the 10 year average of 54%. The largest deals came from Pemex ($7.5 bln across 3 tranches, 10yrs priced @ +507, 30yrs at +545), Apple (issued $7 bln in a drive by, 10yrs priced at +78, 30yrs @ +103) and Disney (issued $7 bln with use of proceeds for bond tender, 10yrs priced @ +70, 30yrs @ +95). Supply related to M&A was a modest $6.8 bln while the pipeline of pending M&A-related issuance remained stable. The three large pending M&A deals are Tmus/Sprint (merger is still in the negotiating stage with the various regulatory federal and state bodies,~ $20 bln debt issuance if approved), ABBV/AGN ($30 bln potential funding needs) and Mylan/Pfizer off patent drug business ($12 bln issuance implications).

Monthly Supply Volumes

Source: BofA Merrill Lynch Global Research

Maturity Distribution of Supply

Source: BofA Merrill Lynch Global Research

U.S. IG Maturities and Additional Redemptions

Note: Detailed redemption amounts data by type is grouped by effective dates.
Source: Bloomberg, ICE Data Indices, LLC, BofA Merrill Lynch Global Research

USD IG Supply Related to M&A ($bn)

Source: BofA Merrill Lynch Global Research

Pipeline of Pending M&A Deals With IG Issuance Implications ($bn)

Source: BofA Merrill Lynch Global Research, Bloomberg

Disney Issues Lowest 30yr Coupon on Record

 

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