2019 Q4 Investment Grade Commentary
Investment grade credit ended 2019 on a high note with another quarter of positive total returns. The Bloomberg Barclays US Corporate Index closed the year at an option adjusted spread of 93, a whopping 22 basis points tighter on the quarter. Treasuries of all stripes sold off during the quarter which mitigated the impact of tighter spreads. The 10yr Treasury closed 2019 at 1.92% after opening the 4th quarter at 1.66%, an increase of 26 basis points. The dichotomy of returns between 2018 and 2019 was stark. While 2018 was a disappointing year with the worst returns for corporate credit in a decade, 2019 was a complete reversal with the best returns in over a decade. For the full year 2019 the Bloomberg Barclays US Corporate Index had a total return of +14.54%. This compares to CAM’s gross total return of +12.78% for the Investment Grade Strategy.
As long-time readers know, our specialty at CAM is bottom-up credit research. We seek to invest in the most attractive corporate credit opportunities for our clients at any given time with the goal of generating superior risk adjusted returns. Preservation of capital is always at the forefront of our decision making process, which is one of the reasons we are always structurally underweight the riskier BBB portion of the investment grade credit market. We are not in the businesses of making speculative market bets, such as wagering on the direction of interest rates, but we certainly do have a framework and house view that we use to aid in our decision making process. To that end, we thought it would be helpful to explore some of the themes that we believe could influence the direction of the market in 2020. We expect four distinct factors could impact the fortune of the investment grade corporate credit market in the coming year: issuance, fund flows, foreign demand and fundamentals.
Issuance is Key
Net issuance is a metric that we track to gauge the availability of new investment opportunities. Net issuance is simply the gross amount of new corporate bond issuance less the amount of debt that matures or that is redeemed through call options or tender offers. Both gross and net issuance have been falling since 2017.
The net issuance forecast for 2020 is substantially lower relative to 2019 and some predictions have 2020 net issuance coming in at or near 2012 levels A few of the major investment banks are particularly bearish in their forecasts: Morgan Stanley expects net issuance to be down 22%, Bank of America down 21% and J.P. Morgan down a staggering 36%. i The decline in net issuance could be meaningful for the support of credit spreads. If continued inflows into corporate credit meet substantially lower new issuance this could create a supply-demand imbalance. This imbalance would create an environment that lends support to tighter credit spreads.
Inflows & the Incremental Buyer
IG fund flows have been broadly positive dating back to the beginning of 2016. The only period of sustained outflows from investment grade in the past four years was during the fourth quarter of 2018 which was a time of peak BBB hysteria.ii iii Over $300bln of new money flowed into IG mutual funds, ETFs and total return funds in 2019, according to data compiled by Wells Fargo Securities. The biggest story of 2019 as it relates to flows is the reemergence of the foreign investor, who has become the most important incremental buyer of IG corporates.
Foreign investors were largely quiet in 2018 but in 2019 they poured $114bln into the U.S. IG market through the end of the 3rd quarter.iv Two factors have led to resurgence in foreign demand: First, for those investors that hedge foreign currency, the three Fed rate cuts in 2019 have made hedging much more attractive, as hedging costs are closely tied to short-term rates. Second, and perhaps the larger factor, is the negative yields that foreign investors have faced in their domestic markets. Negative yielding debt reached its zenith in August of 2019 at over $17 trillion. Although it has come down substantially, it remained over $11 trillion at year-end relative to $8 trillion at the beginning of 2019.v
Obtaining precise information on foreign holdings is difficult due to the myriad of ways that this group can invest in the U.S. markets; but what was once a bit player in our market has now become the single largest class of investor, holding an estimated 30-40% of outstanding dollar denominated IG corporate bonds. To put that into perspective the next largest holder is life insurance companies at just over 20%.vi Simply put, inflows are important in order to provide technical support to the credit market, but the real bellwether for flows is the foreign buyer. If foreign money continues to flow into the $USD market, we would expect continued support for credit spreads. However, if foreign investor sentiment sours, it will create a headwind for spreads.
Best of Times & Worst of Times
Although corporate credit performed well in 2019, credit metrics for the index at large have deteriorated and leverage ratios are near all-time highs. We would typically be apt to view such a development through a bearish lens; but the reality is that much of the increase in leverage reflects conscious choices by firms rather than a weakening of business fundamentals. Incentivized by the minimal additional cost incurred for funding a BBB-rated balance sheet relative to an A-rated one, many firms have sacrificed their higher credit ratings to fund priorities such as acquisitions and share repurchases. Investor demand for credit and a prolonged period of historically low interest rates have reduced the financial penalty for moving down the credit spectrum.
Interestingly, a vast majority of BBB-rated debt has remained in the upper notches of that category. According to data compiled by S&P, just 16% of BBB- rated debt is in the lowest BBB minus category while 47% is mid-BBB and 36% is rated BBB+.vii There will surely be some losers in this bunch which makes the BBB story an idiosyncratic one; managers need to choose credits carefully in this space and focus on those which can weather a downturn without putting credit metrics in serious peril. The median GDP forecast for 2020 is 1.8%.viii If this comes to fruition then most IG-rated companies will be able to maintain stable to improving credit metrics for the year which would be another positive for credit spreads. If growth underwhelms, it would not surprise us to see spread widening in more cyclical sectors and in the lower tier of investment grade credit. This is where our individual credit selection factors in heavily.
At over a decade in length, we are in the midst of the longest credit cycle on record yet the current backdrop suggests that it may have more room to run. Investment grade as an asset class is still compelling as part of an overall asset allocation but even the most bullish investor cannot expect 2020 to be a repeat of 2019 as far as returns are concerned. The fact is that there is not much room for error and there are several risks that will continue to loom large on the horizon in 2020.
- Private equity companies are starting the year with a record $1.5 trillion in unspent capital. This is not a new story and remarkably this same “record” headline could have been written at the start of each of the last four years!ix Private equity is not bad, per se, but when they become involved with investment grade rated companies it is usually to the detriment of bond investors. Understanding the intricacies of each business in the portfolio and the covenants within each bond indenture can help to avoid a bad outcome.
- Policy risk remains high. The Federal Reserve has telegraphed a relatively neutral policy in 2020, which is typically the stance that is taken in an election year, but any deviation from this path could be a shock for markets. The events leading up to the November election and its results both have the ability to effect the direction of credit spreads and the risks are skewed to the downside at current valuations.
- Trade disputes have serious potential to derail domestic and global economic growth. The reality is that until uncertainty is removed, the market is subject to volatility and headline risk associated with global trade. The implications at the sector level are particularly severe in some instances and we are positioning the portfolio to mitigate this risk accordingly.
As always please do not hesitate to call or write us with questions or concerns. We will continue to provide the best customer service possible and to prudently manage your portfolios to the best of our ability. Thank you for your partnership and continued interest. We wish you a happy and prosperous new year.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.
i Bloomberg News, December 30, 2019 “U.S. Corporate Bond Sales to Slow in 2020 With Speed Bumps Ahead”
ii The Wall Street Journal, September 20, 2019 “There Have Never Been So Many Bonds That Are Almost Junk”
iii Bloomberg, October 11, 2018 “A $1 Trillion Powder Keg Threatens the Corporate Bond Market”
iv Bloomberg News, December 26, 2019 “The Corporate Bond Market’s $100 Billion Buyer Is Here to Stay”
v Bloomberg Barclays Global Aggregate Negative Yielding Debt Index
vi Federal Reserve System
vii S&P Global Ratings, December 16, 2019 “U.S. Corporate Credit Outlook 2020 Balancing Act”
viii Bloomberg Terminal, January 2, 2020 “US GDP Economic Forecast”
ix Bloomberg News, January 2, 2020 “Private Equity Is Starting 2020 With More Cash Than Ever Before”