Markets: The current reallocation

| August 17, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A handful of investors, at insurance companies mostly, have mentioned recently their ongoing shift away from investment grade corporate credit and into other things. MBS and consumer assets are getting some of the flow, although other sectors may be seeing it, too. It partly reflects a diverging view of credit. Investment grade corporate credit is getting marginally worse. Household credit still looks relatively strong.

The concerns about corporate credit

Most of the concern seems to revolve around the ballooning class of ‘BBB’ corporate issuers, who now contribute 50% of nonfinancial investment grade debt. This is double the share of the 1990s. This exposes a larger share of any investment grade portfolio to the cliff between investment and speculative grade debt. Not only do spreads widen on the debt – the spread gap between the average ‘BBB’ and ‘BB’ issuer now more than 80 bp, according to the ICE BofAML US Corporate OAS – but speculative grade issuers lose access to prime commercial paper markets. In fact, even slipping from ‘BBB’ to ‘BBB-‘ drops an issuer out of the A-2 commercial paper market. The tools for managing the ebbs and flows of corporate liquidity then begin to narrow.

The surge in US mergers and acquisitions this year has heightened the risk. Announced transactions through June tallied almost 500 deals with a value of more than $700 billion. Although the number of deals roughly aligns with the first half of 2017, the value is by up nearly 65%. A number of these deals have raised the acquirer’s leverage and led to downgrades from ‘A’ to ‘BBB’. Even in advance of the leverage created by M&A, leverage by most measures – typically debt, net of cash, as a multiple of gross earnings – had increased across all rating categories over the last few years but fastest among ‘BBB’ issuers.

The epicenter of it all seems to be in consumer product companies, where weak revenue growth and changing consumer preferences have left issuers scrambling. E-commerce has put pressure on brick-and-mortar retail customers of these issuers and made the customers more demanding and less likely to tolerate price increases. M&A has been a way for acquirers to try to reduce costs through scale, although it has led to leverage well above historic levels. Rating agencies claim that strong cash flow should allow the companies to deleverage or, in a stress case, cut back on dividends and sell assets to support their ‘BBB’ rating. But many of these issuers have been cutting costs for years, possibly leaving little room for further scale efficiencies.

In at least a few cases, the rating agencies have started extending the window for newly leveraged ‘BBB’ issuers to pay down debt. Traditionally, rating agencies have expected deleveraging with 18-to-24 months. Now, in some cases, the window extends to 36 months or longer. That begins to expose vulnerable balance sheets to the risk of a softening economy or even recession.

A steady consumer

By comparison, with the possible exception of households heavy with student debt, consumers look relatively strong. The household debt service ratio for mortgages now stands near the lowest levels since at least 1990. Owners’ equity as a percent of household real estate value has rebounded to pre-2008 levels. Credit card debt as a share of disposable income also stands near the lowest levels since the 1990s. And the ratio of household net worth to disposable income is at the highest level recorded since 1947. Rising student debt has created some pockets of weakness, and rising subprime auto lending since 2008 has led to rising aggregate delinquencies on auto loans. In general, the household picture is good.

Exhibit 1: Historic high for household net-worth-to-disposable income

Source: Federal Reserve

The current reallocation

The anecdotal reallocation out of investment grade corporate debt and into other sectors has some support in broader data. Investment grade corporate debt has probably delivered one of the weaker performances so far this year, trailing both agency MBS and even high yield, although high yield this year has had the benefit of a nearly 30% drop in issuance. The day-to-day correlation between changes in investment grade spreads and agency MBS spreads has also weakened. When the correlation is high, the two sectors are generally moving with the overall beta of spreads. When it weakens, then either something unique is happening in one or the other sector or investors are reallocating between them.

Investment grade corporate debt has clearly become riskier. The liquidity of the sector means that any material reallocation takes time. Capital has started to move.

* * *

The view in rates

The forward curve now implies only 16 bp of yield spread between 2- and 10-year Treasury notes at the end of the year, and 14 bp at the end of the first quarter of 2019. The curve looks likely to be flatter than that, and possibly inverted early next year. The catalyst looks likely to be a repricing of the market to the path implied by the Fed’s dots. The Fed expects to hike three times next year while the market begrudgingly expects slightly more than one. Bet on the Fed. Barring an expansion of tariffs, which, if it comes, would most likely happen after the November elections, the Fed has a credible case for taming growth and inflation with higher rates.

The view in spreads

Spreads are responding to a range of factors these days: a withdrawal of Fed liquidity, a changing profile of risk in parts of the corporate debt market, the usual array of transitory supply and demand influences. Liquidity and rising risk look likely to win in the long run, and both auger for wider spreads.

The view in credit

Fundamental credit broadly still looks reasonable, but more sectors continue to show small warning signs. Leveraged loans, which almost exclusively float off LIBOR, could see coverage ratios drop into riskier territory if the Fed keeps following the dots. Spotty liquidity in CMBS and flat prices for the last 18 months in CRE signal flagging demand. And the large BBB corporate market continues to see M&A transactions where the rating agencies give the acquirer leeway well beyond the usual 18 to 24 months to bring leverage back to pre-acquisition levels. That leaves the corporate market exposed if the economy softens. Risk across credit continues to creep up.

john.killian@santander.us 1 (646) 776-7714

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