Peak Technicals Emerge in IG

Credit Update

December 18, 2019

Much ink has been spilled this year on the topic of how strong the technicals are within the investment grade credit market and for good reason as they have been the dominant underlying driver of overall IG spreads all year. The resurgent strength derives from this year’s re-expansion of central bank balance sheets, which has resulted in a relentless supply/demand imbalance for IG bonds.Demand for IG credit reached a year-to-date peak in November, particularly in the second half of month as the pace of primary market new issuance slowed. A few indicators of this demand could be seen in retail flows as both mutual fund and ETF inflows peaked and as foreign buying also soared as evidenced by net dealer to affiliate volume, per Trace data. Foreign demand for “yieldly” U.S. dollar bonds was further supported in November by the ECB’s purchasing of €5.917B in euro denominated corporate bonds as they resumed quantitative easing via their Corporate Sector Purchase Program. The relative value of euro denominated debt vs. U.S. dollar denominated debt has been stretched all year (EUR bonds trading rich to USD bonds, currency adjusted) and now that the ECB has put its buying shoes back on, the valuation incentive to shift into USD bonds from EUR bonds is likely to persist. At the same time demand appeared to peak in November the window for the new issue and secondary markets to meet this demand began rapidly shrink. New issue supply tapered off considerably during the last 10 days of the month and at the end of November investors were staring at a calendar containing only 15 settlement days left in the year prior to the week that includes December 25th. For a tangible example of these technicals at work in November, one needs to look no further than the AbbVie new issue that priced November 12, when the company issued $30 billion worth of bonds to fund its purchase of Allergan. Setting aside the fundamental merits of the deal and relative value, which we will discuss more below, this transaction on the surface appeared to embody the primary risks that have weighed on the minds of credit investors for most of the year. The company stretched its balance sheet to 4x gross leverage from 2.4x, which is expected to result in a downgrade to Baa2/BBB+ from Baa2/A- if/when the deal ultimately closes. From a technical standpoint, the deal required a ~$30 billion BBB rated bond deal to clear the market. In addition, the healthcare segment of the market has underperformed and suffered from bouts of volatility throughout the year on the back of uncertainty from potential healthcare reform. In this context, AbbVie is a credit that could arguably be in the cross hairs of “policy risk” at least until the 2020 general election. Adding it all up, the 2019 IG market “playbook” suggested that this deal would require a concession to clear and AbbVie bonds underperformed accordingly after the transaction was initially announced in June. However, the strong demand backdrop that emerged in November enabled AbbVie to issue their $30B of BBB rated bonds at a negative 5 basis points (bps) concession (vs. the prior day), 15bps through where their bonds were trading two weeks prior and their bond complex managed to perform further with the newly issued bonds ending the month 15bps tighter than where they priced at new issue. The demand signal from the AbbVie deal appeared to catch the entire market off guard and arguably helped spur a broad-based rally with spread compression led by the cohort of credits and sectors that had been lagging the market for much of 2019. Once again, technicals overwhelmed and the Barclays Credit Index closed the month at new YTD spread tights of 100bps over Treasuries.

Buy the Rumor, Sell the News

Source: Bloomberg Barclays

AbbVie New Issue Tranche Summary

Source: Bloomberg Barclays

Starting in October Big 4 CB Balance Sheets Again Expanding

Source: Federal Reserve, ECB, BOJ, PBOC

Fed Narrative for 2020 Went From Hikes to Cuts to Soft Landing

Source: Fed, Bloomberg Finance LP, DB Global Research

High Grade Fund and ETF Flows, $bn

Note: data are for US-domiciled funds only.
Source: EPFR Global

Net Dealer Buying From Affiliate (12yr+)

Note: Net dealer-to-affiliate volumes are correlated with foreign buying/selling. Negative numbers indicate foreign buying.
Source: Bloomberg, TRACE

ECB Corporate Sector Purchase Program (CSPP) Monthly Net Purchases

Source: Bloomberg

European Issuers: Relative EUR and USD Spreads

Note: the chart plots issuer-matched spreads on a fully currency hedged basis. We use maturity matched cross currency basis swaps to fully currency hedge principal and interest rate payments, and forward FX rates to fully hedge the stream of payments. We also adjust for the difference in quoting conventions with a 3 to 6M Euribor swap.
Source: BofA Global Research, Bloomberg, ICE Data Indices, LLC

The Amount of Negatively Yielding Bonds in Global Aggregate Index Ticked Down in November but Remains High

Source: Bloomberg

While technicals continued to win the tug of war with fundamentals, November did manage to bring a renewed fundamental risk back to the forefront after Bloomberg reported on November 5th that Walgreens had explored taking the company private. The report appeared to gain incremental credibility after a follow up Bloomberg report that KKR was preparing to make a formal offer for the company. The story held credence since KKR had partnered with the current Walgreen’s CEO back in 2007 to execute the take-over of Alliance Boots. This led investors to contemplate the feasibility and implications of what would in theory be the largest LBO in history (current title held by the $45B TXU LBO in 2007) and Walgreens spreads proceeded to widen 65bps over the following two weeks. Spreads on Walgreens bonds managed to end only 20bps wider on the month as the overall market rally took hold during the back half of the month, but this story has yet to play out. It’s worth noting that all of Walgreens bonds have a $101 change-of-control covenant, which if triggered would provide some protection, as all bonds were trading close to $101. Naturally this headline caused investors to dig into the change-of-control language within each Walgreens bond indenture to determine if a transaction could be structured in a way that would avoid triggering the covenant. With the average price of the Barclays Long Corporate Index sitting at $118.66 (as of 11/29), this topic could be increasingly relevant to the market, as even bonds that contain a $101 change of control put could still have considerable mark-to-market downside in the event of an LBO.

Walgreens 4.8 11/18/2044 Spread to Treasuries

Source: Bloomberg

Index Performance

The Barclays Credit Index closed the month another 5bps tighter at +100bps over Treasuries, which is 18bps away from the cycle tights of +81 hit in February 2018. This doesn’t take into account changes in the index composition that have occurred (duration has extended, dollar prices are higher, average leverage is higher, etc.) and one could argue that we are even closer to nominal cycle tights if you attempt to normalize the index OAS for these changes (see exhibit below for an example.) Whether measured nominally or adjusted, market spreads are clearly at the tight end of the range, yet November produced another leg of spread tightening with compression that occurred by rating, sector and among idiosyncratic credits stories that trade wide to the overall market. By the end of the month a classic “compression trade” had taken hold as many unloved credits found renewed sponsorship. Tobacco stands out as one of the more notable examples of this brand of compression, as investors scoured the universe of remaining opportunities to help meet spread and/or yield bogeys. For most of the year performance of Tobacco bonds was suffering from death by a thousand cuts including weak earnings from British American Tobacco in Q4 2018 that delayed the company’s deleveraging plans (after its purchase of RJ Reynolds in 2017), an $11.5B new issue with a large concession from Altria in February to fund the purchase of a stake in Juul, news of vaping related health concerns, an unexpected deal from British American Tobacco in September (also with a meaningful concession) and we surmise ESG is a growing consideration for segments of the IG buyer base. None of these issues were resolved in November yet investors set enough of their concerns aside to enable Tobacco spreads to tighten 15bps on the month which was the best performing industry on the month in term of excess return. Other notable outperformers included healthcare related sectors such as Health Insurers (-10bps) and Healthcare (-8bps) despite the $30B AbbVie new issue as described above. Cyclical sectors also outperformed including Autos in the face of continued tariff headlines (-9bps), Metal and Mining (-10bps) and Independent Energy (-10bps) after being the worst performing and only sector to widen in the prior month. Energy Transfer Operation LP was another idiosyncratic mover on the month as spreads widened 9bps on the back of news that the FBI opened a corruption investigation into how permits were granted for the construction of one of its pipelines (Mariner East in Pennsylvania.) Separately, a sell side report suggested the company might be the target of a take-private transaction. While nothing more than speculation. the report nonetheless caused the bonds to widen further with the market already on edge after the Walgreens LBO headline earlier in the month.

November Index Return Summary

Source: Bloomberg Barclays

November and YTD OAS Change Summary (Barclays Class 4)

Source: Bloomberg Barclays

Barclays Credit Index Summary Stats

Source: Bloomberg Barclays

Rating/Duration/Price Adjusted Spreads* are Meaningfully Tighter Than Nominal Levels

*Rating and duration weights based on 2004-2006 average. Price adjustment made using BCDS spreads. OAS axis truncated for clarity.
Source: Bloomberg, Barclays Research

High Grade Sector Excess Return

Source: BofA Merrill Lynch Global Research, ICE Data Indices, LLC

November Investment Grade Supply

The pace of supply picked up in November to $103B which followed a light $85B of supply in October that was down 12% from October 2018 to stand as the lightest October since 2013. Supply was front loaded as almost 3/4 of total supply in November came to market in the first two weeks of the month, including the $30B AbbVie deal on November 12th. AbbVie was the largest deal in 2019 (followed by $20B from IBM and $19B from Bristol-Meyers Squibb) and the fourth largest deal on record. As previously mentioned, this transaction involved a number of the key risks that weighed on the minds of IG credit investors in 2019 (re-leveraging, a downgrade to BBB, heavy supply) but it is also is good example of the opportunity set that TCW has been finding value within all year. The combined company will generate ~$18B of free cash-flow (pro-forma estimated in 2019 before dividends) which will give it the abliity to execute on what we view as a credible deleveraging plan and will result in a company with increased scale and diversification to strenthen its credit profile long term. The 30yr tranche was issued at a spread of 190bps over Treasuries, offering attractive compensation and relative value vs. what we view as an unattractive market spread overall, particularly as this was very flat in spread to some of the more cycliclal segements of the market including Metals and Chemicals.

The heavy pace of supply early in the month led to some supply indigestion in the first three weeks of the month, which in turn contributed to modest intra month spread widening/volatlity. Still the market proved to be very resilient, helped by the pent up demand from light supply in October. For example, during the holiday-shortened week that AbbVie came to market the index widened only 2bps even as dealers net purchased an estimated $3.7B of bonds (Trace data estimated by Bloomberg) with $1.1B in the Healthcare sector as investors rotated into into the AbbVie new issue. The market procceded to rally during the last week of the month with a successful AbbVie deal in the rearview mirror, technicals clearly strong and very light supply on deck for the balance of the year.

Monthly IG Supply

Source: BofA Merrill Lynch Global Research

Supply Related to M&A Reached $34.2bn in November

Source: BofA Merrill Lynch Global Research

US IG New Issue Performance Improved in November

Source: BofA Merrill Lynch Global Research

Heavy Selling During the Holiday Shortened Week of the AbbVie Deal

Source: Bloomberg Barclays

Credit Index OAS

Source: Bloomberg Barclays

Summary of Fallen Angels, November, 2019

Source: BofA Merrill Lynch Global Research, ICE Data Indices, LLC

Summary of Rising Starts, November 2019

Source: BofA Merrill Lynch Global Research, ICE Data Indices, LLC

 

 

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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. © 2019 TCW