November Credit Update

Monthly Commentary

December 02, 2016

November was an interesting month for the markets. In Brexit-like fashion, the unexpected Trump win caused most U.S. credit and equities markets to trade off initially, only to retrace and reset at new highs. From a sector standpoint, the biggest winners post Trump were those that stand to benefit most from a less burdensome regulatory environment, including potential changes to Dodd-Frank. Additionally, fiscal expansion via tax cuts, a repatriation holiday and/or increased government spending (on defense and infrastructure) is expected to benefit sectors like metals, defense, manufacturing and construction. A repatriation tax holiday would be most beneficial to the tech sector, followed by healthcare, as those sectors have massive amounts of cash held abroad. It is estimated that about $1 trillion in cash is held overseas by U.S. IG issuers. Even if some or most of the repatriated cash is used for share buybacks, M&A, and/or dividends (as opposed to debt reduction), it could still significantly lessen debt issuance needs for these issuers. On the flip side, Trump’s expansionary agenda of corporate tax cuts and less regulation could re-stoke animal spirits, which would also have the effect of prolonging the credit cycle by fueling more balance sheet deterioration at a time when leverage metrics are at peak levels and valuations are stretched.

Credit performance: The yield on the IG credit index rose 43 basis points in November to 3.284% on the heels of a 50 basis point backup in Treasury yields. This resulted in the biggest monthly negative return (-2.73%) since September 2008. Index spreads were tighter by 2 basis points in November though performance was bifurcated – with EM/Sovs the notable underperformer. This is reminiscent of the 2013 taper tantrum where EM underperformed as higher rates prompted capital outflows. In fact, November saw the largest weekly outflow (-$6.64 billion) out of EM funds going back to 2009. Muni funds also experienced significant outflows, totaling $6.45 billion (1.6% of AUM) for the three weeks post election. Outflows out of high grade funds were more benign, averaging about -$1 billion per week since the election – so the big move in rates hasn’t resulted in meaningful outflows out of high grade from retail investors. What we saw instead was an increase in demand for long-dated corporates from yield-sensitive buyers (pension, insurance). The result was a significant flattening (~ 8 basis points) of the 10-30’s credit curves for many liquid industrial issuers (see chart).

Sector performance: Best performing sector was life insurance – with higher rates/yields being the catalyst – followed by metals, railroads and technology. Energy spreads were little changed leading up to the November 30 Organization of Petroleum Exporting Countries (OPEC) meeting in Vienna but moved tighter as oil rallied more than 9% after the agreed-upon production cuts — the first mandated cuts since 2008. The parameters of the agreement include a 1.2 mbpd production cut to 32.5 mbpd starting in January. The biggest cut will come from Saudi Arabia at -486 kbpd, followed by Iraq at -210 kbpd. Iran production will be capped at 3.8 mbpd under this agreement, which is near pre-sanction levels. Moreover, non-OPEC members have agreed to cut production by an additional 600 kbpd (with Russia accounting for half of that cut). The duration of this agreement is six months, extendable for another six months. Now that there is a deal, markets will look towards implementation and execution, which likely faces significant hurdles. Additionally, price increases in oil will be met with increased U.S. shale production, which has fallen ~ 1 mbpd since its 2015 peak level.

Worst performing sectors: Only five subsectors posted negative excess returns. Sovereigns and Quasi Sovereigns were the worst performing sectors at -1.22% and -.54% excess returns. Both of these sectors are comprised mainly of EM issuers (Mexico, Peru, Colombia, S. Africa and the Philippines ) which have seen weakness post the election. While commodity prices remained resilient (in great part due to OPEC deal) in the face of a stronger dollar, concerns over a more protectionist U.S. trade policy have negatively impacted EM spreads.

Supply: Supply moderated to $77 billion in November, the lowest issuance month YTD. Four large M&A related deals accounted for 25% of supply, including ABT (to fund STJ, $15.1 billion across six tranches, 10yrs priced at +155) and ADI (to fund Linear, $2.1 billion across four tranches, 10yr price at +120). Demand was strong and new issue concessions continue to be negligible, with several deals printing inside secondary levels (negative concession).

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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. © 2018 TCW