October Credit Update

Monthly Commentary

November 06, 2018

October was a volatile month for risk assets as anxiety over “peak” earnings, EM volatility and European weakness (Italy, Brexit) all weighed on the market. The credit index OAS of +112 basis points over Treasuries widened 12 basis points in October, the weakest month in over two years. The YTD excess return of -0.79% reflects moderately wider spreads (+23 bps YTD) while the YTD total return of -3.49% is the worst since 1994, driven in large part by higher risk free rates. Though the IG credit market has experienced meaningful widening since touching the post crisis tights of +81 in February ’18, spreads are still tight on historical and risk adjusted (spread per turn of leverage) basis. The technicals, which have been the main drivers of credit performance over the last ten years, have begun to turn in the face of tightening global conditions. For the first time in long time, fundamentals are taking precedence over technicals. The shift in investor sentiment has been notable as investors looked past a solid earnings season and focused on forward guidance and earnings sustainability in the face of an aging cycle and tightening global liquidity. For credit investors, the resurgence of debt-funded M&A activity has put continued pressure on credit metrics. As a consequence, the ratings quality of the credit universe has deteriorated, with BBB’s now accounting for 44.69% of the index, even as credit rating downgrades have been limited and issuers given the benefit of aggressive post deal de-leveraging promises – though rating agency patience may be running out. Case in point, Moody’s put Inbev’s (Abibb) A3 rating on downgrade watch on October 1st, citing lack of progress on deleveraging since the SabMiller acquistion closed in 2016. Specifically, Moody’s noted that the company’s adjusted leverage of 5.4x as of June 2018 was well beyond the 4.0x expected year end 2018 leverage. While the company subsequently cut its dividend by 50%, or ~ $4 bln annually (which equates to .2x of leverage), it may not be enough to avoid a downgrade. At 2.57%, Abibb is the 7th largest issuer in the single A index. Current ratings are A3/A-/BBB, thus, any downgrade by Moody’s would cause the credit to fall out of the single A index.

YTD Total Returns

Source: Bloomberg Barclays

Annual Excess and Total Returns: YTD Total Return of -3.49% is the worst in over two decades

Source: Bloomberg Barclays

IG Credit Index Yields and Spreads: Index yield of 4.203% is 20 bps higher MTD, 100 bps higher YTD.

Source: Bloomberg Barclays

Credit quality of the IG universe has shown significant deterioration Quality Analyis of Barclays Credit Index, 1973-2018

Source: Bloomberg Barclays

Spreads are tight on a risk (leverage) adjusted basis

Source: Bloomberg Barclays

At 59 bps, BBB vs A spreads are close to the tight end of the post crisis ranges, albeit the single A universe is shrinking. Higher quality has not outperformed. Ratings deterioration from some large single A issuers has been the culprit.

BBB vs. A Spreads

Source: Bloomberg Barclays Indices, Barclays Research

Q3 earnings have been healthy, up 23% YoY for the IG issuers:

Note: 3Q18 based on the actual results when available and consensus estimates otherwise
Source: BofA Merrill Lynch Global Research, FactSet.

Note: 3Q18 based on the actual results when available and consensus estimates otherwise
Source: BofA Merrill Lynch Global Research, FactSet.

Earnings Growth by Sector

Source: BofA Merrill Lynch Global Research, FactSet

Index Performance: The credit index OAS of +112 basis points over Treasuries was 12 basis points wider on the month. Higher Treasury yields coupled with wider spreads produced negative excess (-0.80%) and total (-1.40%) returns. Spread performance was generally weak across the board though we saw some decompression with BBB’s underperforming, led by cyclical sectors like autos, sovereigns (em) and refiners. Autos are the worst performing sub-sector on the month (+24 bps) and YTD (+55 bps) as headwinds for the sector continue. Margin pressure on rising input costs coupled with a slowdown in China sales have been catalysts for spread widening. The Chinese market has been an important growth vehicle for the OEMS, and while sales growth had been decelerating for the last couple of years, it has recently turned negative.

Best performing sectors on the month were munis (+5), REITs (+5), utilities (+6) and banks (+9). The common thread among these four outperformers is lack of event/M&A risk. Utilities and banks are regulated sectors, REITs have bondholder protections via covenants, and taxable muni’s are mostly high quality GO’s (state GO’s typically backed by the full faith and credit of the state) or revenue bonds.

October Credit Index Returns

Source: Bloomberg Barclays

MTD OAS Changes by Sector

Source: Barclays Capital

YTD OAS Changes by Sector

Source: Barclays Capital

October Investment Grade Supply: October supply volumes were $96 bln, down 34% from September’s $145 bln figure. Financial supply of $27.9 bln was surprisingly light post bank earnings, which helped the sector outperform on the month. Industrial supply totaled $68.1 bln, including $38 bln in M&A-related issuance. The largest deals came from Comcast and Conagra Brands (CAG). Comcast issued $27 bln across 9 maturities to the fund the acquisition of Sky; 5yrs priced at +75/5yr, 10yrs priced at +110/10yr, 30yrs priced at +150/olb. CAG issued $7 bln across seven maturities to fund the Pinnacle Foods acquisition; 10yrs priced at +170, 30yrs priced at +210. While new issue concessions improved to 6 basis points (versus 5 basis points in September) due to increased market volatility, deal performance was mixed as spreads continued to widen as the month progressed.

Monthly New Issue Volumes

Source: BofA Merrill Lynch Global Research

M&A-Related New Issue Volumes

Source: BofA Merrill Lynch Global Research

 

Media Attachments


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. © 2018 TCW