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Wild equities, tame credit

admin | October 12, 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.

Correction: updated from version originally published on 10-12-18 where Ford was described as “split-rated.” Ford is rated Baa3 by Moody’s and BBB by S&P. 

If you thought the recent swings in equity markets had a clear message for the economy, then guess again. The latest equity dance showed almost no sign of contagion to investment grade credit. That’s important since an equity drop in expectation of a turn in the economy would likely hit ‘BBB’ spreads especially hard. Instead the latest weakness softened spreads proportionately across ratings, and changes in debt spreads by issuer showed almost zero correlation to movement in the corresponding equity. For now the equity and credit markets are dancing to slightly different tunes.

The long term movement between equity and credit

Historically, there is a reasonable correlation between changes in the equity and investment grade credit markets. Both asset classes tend to perform well as economic growth picks up speed and underperform in downturns. Comparing changes in the S&P 500 index against changes in investment grade credit spreads shows that as the equity market rises credit spreads tend to tighten, and when equities sell off spreads widen (Exhibit 1). The correlation of these changes is 0.40, though this can vary meaningfully across time.

Exhibit 1: A modest relationship between equity and investment grade credit

Source: Bloomberg, Amherst Pierpont

No hints of weakness in ‘BBB’ as equities re-priced

Within the last week the S&P 500, Dow Jones and Nasdaq indices each dropped more than 5% over two trading sessions. Proposed reasons for the drop vary, with many analysts pointing to FAANG stocks and the technology sector in particular as overdue for correction. The sudden move stoked fears of contagion to other assets, and the Treasury market did show signs of a modest flight-to-quality bid, with the 10-year Treasury yield rallying over the two days about 10 bp peak-to-trough .

The reaction in credit markets was even more muted, with investment grade spreads widening about 3 bp. More than 50% of the investment grade universe is now rated ‘BBB,’ and leverage ratios at some of those companies are leaning into what has traditionally been high yield territory. There’s good reason for concern about the impact of any softening in the economy, particularly among the more vulnerable ‘BBB’ names.

So far, there is no indication that the equity re-pricing had any knock-on effect in credit, either by name or by credit rating. Comparing changes in an issuer’s equity (in percent) to changes in the issuer’s bond spreads (in basis points) on 10/10/2018 offers no evidence that the sudden equity sell-off had any meaningful ramification in credit (Exhibit 2). The broad correlation between an issuers’ repricing in equity and debt is nearly zero. Moreover, there was no specific weakness shown in the lower ratings categories.

Exhibit 2: Change in credit spread by issuer vs change in equity price on 10/10/2018

Note: Analysis showt the change in an issuers equity (in percent) versus a change in the issuer’s bond spreads (in basis points) on 10/10/18. The bond spread of an issuer is calculated as the market value weighted average spread to the interpolated Treasury curve for bonds in the liquid universe (at least $700 million outstanding and 3+ years remaining to maturity). We analyzed bonds that are included in the iBoxx Liquid Investment Grade Index and eliminated equity names that trade on foreign exchanges to keep the daily changes contemporaneous. The names are stratified in the graph by ratings category. Source: Bloomberg, Amherst Pierpont.

An interesting outlier

The Ford name cheapened 10 bp on the day, which was a relatively big one day move, but the credit has been widening out steadily for months (Exhibit 3). Ford, whic is rated Baa3 Moody’s and BBB by S&P, has been struggling with sales and buffeted by trade negotiations, and clients have been persistent net sellers of the paper.

Exhibit 3: Ford credit cheapens across the curve for past 6 months

Source: Bloomberg, Amherst Pierpont. Note: the credit spread is calculated as the spread to the Treasury curve on a market value weighted basis for bonds in the liquid universe.

Trading in Ford bonds has recently accelerated into the downdraft, with Trace showing five times the average daily trading volume on 10/12/18, with clients being net sellers, according to a note on Bloomberg. The equity has been sliding steadily since June, and broke below $9 during the recent sell-off. Although the cheapening of the bonds looks attractive, until trade policy is hammered out, the name could remain volatile. Our credit strategist, Don Jones, had this to say:

“Despite the challenges ahead for Ford and the recent sell-off in debt and equity, the long-term upside for Ford is positive. Ford is the kind of credit story that should appeal to long-term investors able to tolerate higher-than-average volatility, and who will expect higher yields in return. We expect that Ford will work with the rating agencies to execute on its 5-year “Fitness Impact” plan in such a way that will maintain the IG ratings. The negative outlooks were put into place in 2018 and we don’t expect them to change before 2H19 at the earliest. Given the fact that F ’23 (Baa3 Neg/BBB Neg/BBB) bonds trade +40 bp wide of GM ‘23s (Baa3/BBB/BBB) and +93 bp wide of Diamler ’23 (A2/A/A-), and +120 bp of the recent American Honda ’23 (A2/A+), there is good reason to expect value buyers will see Ford as appealing for a long-term position.”