Reach-for-Yield Theme Remains

Credit Update

November 07, 2019

October was another good month for risk assets. U.S. equities touched new peaks, volatility (as measured by the VIX) remained near YTD lows and credit spreads tightened 4 basis points. Demand for spread product remained robust as inflows into the asset class continued and IG supply saw a sharp decline vs. September’s near record number. Technicals continued to be the driver of credit spreads as supportive central banks, determined to extend the cycle, offset a tenuous macro environment. The Fed cut rates for the third time this year, delivering another “mid-cycle adjustment” while the ECB is set to resume bond purchases in November. Purchases will total 20 bln euro per month 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.

On the macro front, manufacturing data remains weak, the U.S.-China trade war and Brexit remain unresolved (the Brexit deadline was delayed again, with elections set for December 12), but a better than expected jobs report was enough to allay some fears of recession risk. A good enough economic backdrop and accommodative central banks have kept IG credit spreads in check. Global yields remain near historic lows and the amount of negative yielding debt remains high at ~ $13.3 trillion. While there are pockets of value and opportunity, overall, valuations look stretched as spreads are trading well through long term averages. Credit fundamentals have deteriorated as decelerating earnings growth and record debt issuance have weakened credit metrics. Corporate leverage continues to rise as cheap money drives debt-funded M&A and other shareholder expansion efforts. Moreover, worsening liquidity conditions and rising idiosyncratic risks have not abated. As such, further risk reduction is warranted as the index OAS approaches +100 basis points over Treasuries.

Credit Spreads:


Source: Bloomberg Barclays



Source: Bloomberg Barclays

Mutual Fund Inflows:


Source: Wells Fargo Securities, Bloomberg, L.P.

IG Credit:


Note: 3Q-19 based on the actual results when available and consensus estimates otherwise.
Source: BofA Merrill Lynch Global Research, FactSet

Note: 3Q-19 based on the actual results when available and consensus estimates otherwise. Issuers with large M&A transactions include CI, CMCSA, CVS, DIS, and MPC.
Source: BofA Merrill Lynch Global Research, FactSet


Forward Estimates are Falling

Source: FactSet, BofAML US Equity & US Quant Strategy

The Earnings Bar Has Come Down

Source: FactSet, BofAML US Equity & Quant Strategy

Index Performance

The credit index OAS of +105 basis points over Treasuries tightened 4 bps on the month, bringing spreads closer to the cycle tights of +82 reached in February of 2018. The reach-for-yield theme remained intact as higher beta/BBBs generally outperformed with a few exceptions. Stable Treasury yields and tighter spreads resulted in positive total and excess returns of 0.57% and 0.55% respectively for the month. The YTD total return of 13.26% is the strongest since 2009. The best performing sectors in October were refiners (-12 bps) and life insurers (-11). The worst performing sector was independent energy (+2 bps), on concerns over oil demand and weakness in natural gas-exposed names. The front natural gas contract ended the month at $2.63, a 10% drop YTD as 9-10 bcf/d of added supply has outpaced 5 bcf/d of demand growth. With winter approaching, the drawdown season should provide some reprieve to low natural gas prices. In addition, incremental demand for natural gas will come from LNG facilities coming online – ~2.7 bcf/d in 2020 – which could help mitigate the imbalance. On the year, the best performing sectors are diversified manufacturers (-59 bps), refiners (-58 bps) and wirelines (-57 bps). Diversified manufacturing outperformance can be attributed to the 130 basis points of spread tightening in GE debt. Refiners improved on healthy margins and upcoming IMO (International Maritime Organization) shipping fuel rule changes which should benefit complex refiners. For the wireline/wireless sector, significant de-leveraging progress has been the catalyst for spread outperformance, specifically for VZ and AT&T. Thematically, the BBB non-cyclical sectors that levered up for M&A then de-levered, have outperformed not only YTD but also over the cycle. BBBs have outperformed single As by an annualized excess return of 150 basis points since 2008. As a record number of “fallen As” made the transition out of the single A index into the BBB index, the performance benefit has generally been realized by the BBB cohort. This is because the remediation process has typically occurred after the downgrade – i.e. after the transition from A to BBB.

October Index Returns

Source: Bloomberg Barclays

October OAS Changes by Sector

Source: Barclays Capital

YTD OAS Changes by Sector

Source: Barclays Capital

10/31/19 OAS by Sector

Source: Barclays Capital

October Investment Grade Supply

After near record issuance in September ($166 bln), October volumes of $84 bln underwhelmed the market. On a net basis, $55 bln of scheduled maturities plus $35 bln in additional call/tenders resulted in negative supply of ~ $6 bln. Demand was underpinned by this lighter than expected supply and resulted in new issue concessions that were de minimis. M&A-related issuance was light at $5.8 bln while the backlog of M&A related funding needs remained stable at ~ $70b bln. The largest M&A related deal came from Danaher ($4bln across five maturities to fund acquisition of GE healthcare assets, 10yrs priced at +78, 30yrs priced at +108). Danaher also funded a portion of the purchase with euro bonds which priced at a yield of 75 basis points for the 12 year maturity. When compared to the 2.6% yield for the 10 year U.S. $ bonds, it highlights the relative attractiveness of issuing in the euro market on an unhedged basis.

Monthly IG New Issue Volumes

Source: BofA Merrill Lynch Global Research

Reverse Yankee Issuance Increasing

Source: BofA Merrill Lynch Global Research, Bloomberg

M&A-Related Issuance

Source: BofA Merrill Lynch Global Research

Pending M&A Deals

Note: Bloomberg uses the deal terms and the current market price of the target company to calculate the deal probability that the market is pricing in: (current price less pre-offer price) / (target price less pre-offer price). This approach breaks down when either 1) the current price is below the offer price as would imply a negative deal probability, or 2) when the current price exceeds the target price which would imply a deal probability exceeding 100%.
Source: BofA Merrill Lynch Global Research, Bloomberg




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