Published on January 13, 2020

2019 was an exceptional year for investment grade fixed income, but according to John Sheehan, the market is unlikely to repeat itself in 2020. He feels active portfolio management and effective credit selection will drive performance this year.

As we wrap up an incredibly strong year for investment grade credit, we turn our focus to our outlook for 2020. The corporate investment grade (IG) credit market had its best total return since 2009 as 10-year treasury yields fell ~75 basis points (bps) and spreads compressed by a further ~60bps. This two-pronged drop in yields drove the total return of the Bloomberg Barclays U.S. Corporate Index to 14.5% for 2019.

Annual IG Returns
Source: RIMES Technologies Corporation, Bloomberg Barclays U.S. Corporate Index

At the risk of stating the obvious, we do not anticipate excess returns or total returns in 2020 replicating their performance in 2019. The fears of a recession look to be further off now than this time last year and monetary policy appears to be in a holding pattern for the near-term. We anticipate a moderate uptick in corporate earnings, and investment grade companies continue to show the ability to meet their liabilities and avoid wide-scale ratings downgrades. Given the relatively lofty valuations, we continue to like IG credit but see several competing forces that will ultimately keep spreads rangebound. Below, we lay out both the bear case and the bull case for IG credit in 2020, but in our view the new year will be favorable for investment grade bonds. We conclude this report with our recommendations for the best way to approach the market in 2020.?

THE BEAR CASE

Elevated Leverage

Despite several high-profile large issuers being vocal about paying down debt, the investment grade market as a whole has made very little progress on deleveraging (as measured by debt/EDITDA). The balance sheets of corporate issuers as well as the estimates for growth of the U.S. economy are both consistent with late cycle leverage in the system. The gross debt to EBIDTA ratio for non-financial investment grade issuers now stands at 2.32x, up marginally from 2.27x last year (Morgan Stanley). To put that in perspective, the peak of the 2007 cycle for debt to EBIDTA was 1.75x.

 

IG Leverage
Source: Morgan Stanley

The consensus view continues to be that this level of leverage will be sustainable unless we hit a recession. Looking at corporate debt as a percentage of GDP should give investors pause both in terms of the magnitude of that ratio and the stage of the cycle this implies.


Source: Morgan Stanley

Ratings Are Stretched

By historical standards, the amount of leverage within each rating grade cohort remains elevated. Much of this is a result of large M&A transactions that have been financed by debt. The rating agencies have given the acquiring companies leeway to execute their M&A plans at higher levels of leverage with the expectation that the increase in debt is only temporary. The risk is that a recession and/or failure to execute on deleveraging will force the ratings agencies to pull ratings more in line with traditional levels. A full 39% of the investment grade market would be rated high yield using historical leverage ratings metrics. This is especially noteworthy considering that the IG market is ~6 times larger than the high yield bond market. As we have discussed in the past, we feel this situation is important and we are monitoring it closely.


Source: Morgan Stanley

Lofty Valuations

Three different credit valuation metrics each finished the year near all-time highs, suggesting that in 2020 there may be more downside risk than upside opportunity.

Credit Spreads

The strong credit spread rally of 2019 has left valuations at a relatively tight starting point. While much of the tightening was a reversal of the sharp widening in the fourth quarter of 2018, spreads would need to head back towards the tights of the last ten years in order for IG to outperform significantly.


Source: Bloomberg. *Spreads are option adjusted

Dollar Price

Given the rally in interest rates and compression of credit spreads, the dollar price of the Bloomberg Barclays Long Corporate Index is over $118. All else equal, an investor should prefer a par bond (bond priced at $100) versus a bond at a premium because with the premium bond, investors have $118 at risk with only a $100 claim against the issuer. Barclays estimates the value of the 18 point premium on the index to be ~20 basis points. Said another way, an investor should be indifferent between owning a par bond that yields 20 basis points less or the $118 bond. When we adjust the current spread of the index for the premium dollar price, current levels are now within ~10bps of the post-2000s tight spreads.

Relative Value vs. Mortgage-Backed Securities

The vast majority of the analysis of investment grade corporate spreads focuses on their relationship to Treasuries, but we think it is also important to monitor their relationship to the other major IG asset class, U.S. mortgage-backed pass throughs (MBS). Over the course of 2019, IG credit has substantially outperformed MBS, as corporates benefitted from a favorable economic environment while mortgages have been held back by rate volatility and increased concerns about prepayments given the rally in rates. The Bloomberg Barclays AA Corporate Index started 2019 ~50 basis points behind the Bloomberg Barclays U.S. MBS Fixed Rate Index but traded flat in October. This is an even more impressive move when you look at the tightening on a percentage basis – essentially corporate spreads have tightened from double MBS spreads to even.


Source: Bloomberg. *Spreads are option adjusted

Reliance on Foreign Demand

From 2009 to 2017, overseas investment in U.S. investment grade credit climbed steadily, peaking at nearly 30%. Although it has decreased from its highwater mark, foreign ownership of U.S. corporate bonds is still a significant source of demand.


Source: Morgan Stanley

A potential risk factor for the IG credit market in 2020 is that the opportunities may not look as attractive as they used to for foreign investors (who measure their returns in local currency after hedging costs). Tighter credit spreads and higher hedging expenses reduced returns in 2019, which softened demand. If this trend accelerates in 2020, spreads would need to move wider to attract new foreign buyers.

Returning to our MBS comparison, as you can see in the chart below, hedged agency mortgages now have a higher yield than similar duration high quality corporates for an investor trading in Japanese yen. This suggests foreign investors may be able to rotate into higher credit quality MBS and pick up yield.

 


Source: Morgan Stanley

THE BULL CASE

Improving Credit Fundamentals

The long running economic expansion has allowed some IG issuers to improve their credit fundamentals, which should be additive to returns in 2020.

Debt/Equity Ratios

Much of the discussion around the increase in leverage among investment grade companies focuses on the debt/EBIDTA ratio. While certainly an important metric and historically the market standard, when looking at other measures of leverage across the IG market the picture looks more favorable. As we described in our Not as BBBad as You’ve Heard piece, the typical BBB company today is much different than the typical BBB company in the past. In particular, BBB companies now are much bigger and have substantially more financial flexibility. As such, they have larger equity market capitalizations which highlights the relative strength of today’s BBB company. When looking at debt vs market cap, the leverage story looks much more palatable. While we do not expect many BBB companies to issue equity or cut their dividend to stave off a downgrade to high yield, today’s BBB issuer has a much higher ability to do so.


Source: JP Morgan

BBBs: Stable Leverage

Coming into 2019, the risk of widespread downgrades of BBB investment grade companies to high yield was the predominant concern of the market. In hindsight, this created a great buying opportunity that resulted in 15+ year BBB bonds posting an annualized total return of ~26% (ICE BofA 15+ Year BBB U.S. Corporate Index), nearly matching the return of the S&P 500. It has been our view that it has been a conscious decision by management to be rated BBB: CFOs are doing their job by having the most efficient cost of capital.

Despite last year’s angst about BBBs, 2019 was the most favorable year for IG ratings since 2014, when upgrades last exceeded downgrades across all of IG. Looking specifically at BBBs, ~10% of non-financial BBB debt was upgraded while 3% was downgraded (compared to 9% and 6% historical average). Ratings actions in 2020 will remain a focus and depend upon the health of the economy along with individual company performance. To connect the dots between leverage and ratings, another comforting development for BBBs is that leverage within BBBs has stabilized while the bulk of the growth of leverage within IG is within A rated issuers. We continue to prefer issuers that are keeping leverage in check and trade with additional spread.


Source: JP Morgan 

Strong Market Technicals

Absent a significant deterioration of the economy and/or corporate earnings, which we do not forecast, we expect the supply/demand technical to be the primary driver of investment grade performance in 2020. We see both sides of the supply demand equation being supportive of positive returns. On the supply side, a combination of debt repayment from industrials, substantially lower regulatory liquidity issuance needs from financials, and a moderate M&A calendar should produce the lowest net supply of Investment Grade since 2009. In fact, according to a recent report by BAML, when coupons and tenders are considered, the net supply could be negative in 2020.


Source: Morgan Stanley

We anticipate the demand side (i.e., inflows to funds) being equally constructive as investors will seek the credit quality and additional spread of IG in a year of muted returns. Fund flows into fixed income assets have been robust and we would expect that to continue in 2020. In 2019, U.S. dollar denominated funds that track the Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) received over $100 billion of inflows while U.S. dollar denominated corporate bond funds received an additional $25 billion. Given that the BC Agg has a ~25% weighting to IG Credit, roughly $50billion was invested in 2019. Next year we expect those inflows to sustain, or potentially increase, given the additional spread of corporates versus other IG alternatives.

Lastly, we expect overseas issuers to continue diverting issuance away from U.S. dollar bonds into their home currencies, which will reduce the supply of IG. While not purely efficient, multinational corporations can take advantage of cross-currency arbitrage opportunities and issuers will follow demand across the globe. In fact, one of the main contributors to the drop-off in IG supply in U.S. dollars in 2019 has been a 25% reduction of Yankee (non-US) bank supply, as the financing is back to being more attractive in their home market. Compounding this dynamic, we have seen a 6-fold increase in “Reverse Yankee” issuance of U.S. companies issuing overseas. We are confident that any meaningful drop off in demand from overseas investors will likely be offset by a similar drop-off in supply from issuers.

Carry of IG Is attractive

We are expecting a volatile interest rate environment in 2020, as investors contend with ongoing geopolitical risks and the U.S. presidential election. With the Fed remaining on hold, the net moves on rates will only be modestly higher. Similarly, we think spreads in mortgages and IG credit will both be range-bound. Given this backdrop, the incremental carry and roll-down of IG will make it compelling to remain invested in the sector. The higher carry/yield of IG should allow that asset to outperform Treasuries and/or mortgages, even with a modest widening of credit spreads.

Source: Morgan Stanley

LOOKING AHEAD

In summary, we are targeting a market weighting in IG corporates for 2020. Given the remarkable moves in spreads during 2019, we feel investment grade corporates are priced for near perfection as we enter the new year. Adjusted for the premium prices, spreads are nearing post 2000 tights despite several potential pitfalls, including the ongoing trade negotiations with China and the upcoming U.S. presidential election. Looking ahead, we are cognizant of the risks that could arise from the bear case scenarios we presented, but we believe the biggest risk in IG credit is the current valuation, which should be more than offset by the strong technical supply and inflows into the product. With a neutral sector allocation, we believe it will be a year in which active portfolio management and sector/credit selection will drive outperformance. We envision a wide dispersion of performance of individual credits in a year of muted performance across the sector, in which case careful security selection will be the key to success in 2020.

John Sheehan

Vice President & Portfolio Manager

Written by

John Sheehan

Vice President & Portfolio Manager

John Sheehan

Vice President & Portfolio Manager

John Sheehan graduated from Georgetown University (B.A. Economics). Mr. Sheehan holds the Chartered Financial Analyst designation.

Prior to joining Osterweis Capital Management in 2018, Mr. Sheehan spent more than 20 years working at Citigroup, first as Managing Director responsible for Investment Grade Syndicate in New York City, where he advised issuers on accessing funding in the corporate bond market. Later at Citigroup, he was Managing Director in charge of West Coast Investment Grade Sales in San Francisco, where he covered several of the largest U.S. investment grade credit investors.

Mr. Sheehan is a principal of the firm and a Portfolio Manager for the total return fixed income strategy.

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The Bloomberg Barclays U.S. Corporate Index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes exclusively corporate sectors, including Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations.

The Bloomberg Barclays U.S. Aa Corporate Bond Index includes only the Aa-rated subset of the Bloomberg Barclays U.S. Corporate Index. The index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes exclusively corporate sectors, including Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations.

Bloomberg Barclays Long U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market whose maturity is 10 years or longer.

The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Fixed Rate Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.

The ICE BofA U.S. Investment Grade Index tracks the performance of U.S. dollar denominated investment grade debt publicly issued in the U.S. domestic market.

The ICE BofA 15+ Year BBB U.S. Corporate Index is a subset of the ICE BofA U.S. Corporate Index including all securities rated BBB1 through BBB3, inclusive, with maturities 15 years or greater.

Investment grade bonds are bonds with high and medium credit quality assigned by a rating agency. For Standard and Poor’s, investment grade bonds include BBB ratings or higher. For Moody’s, the cutoff is Baa.

High-yield, or “below investment grade” bonds, include bonds with a lower credit rating than investment-grade. These bonds typically pay higher coupons as they are riskier.

A basis point is a unit that is equal to 1/100th of 1%.

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.

Leverage ratio is a financial measurement that looks at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations.

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.

Interest coverage ratio is a measure of a company’s ability to service its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position.

The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its shareholder equity.

Credit Quality weights by rating were derived from the most recent data available as determined by Standard and Poor’s. Grades are assigned to bonds by private independent rating services such as Standard & Poor’s and these grades represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. In situations where Standard & Poor’s has not issued a formal rating, the security is classified as not rated (NR). Additionally, common stocks, if any, are classified as NR.

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