Uncategorized

A bifurcation across investment grade credit

| November 16, 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.

Investment grade credit spreads have jumped wider, led by an under-performance of ‘BBB’ rated debt. After hitting historical tights early this year, the level of spreads are back to those of late 2016 to early 2017. The momentum of the move clearly caught some investors off-sides, and there could be moderate follow-through in coming weeks. A bifurcation across ratings categories is already evident and could increase, as ‘BBB’ rated entities with heavy debt loads and lower growth opportunities absorb the brunt of the sell-off.

A sharp move wider

The investment grade corporate credit universe is now roughly one-half ‘BBB’-rated debt. The liquid investment grade universe – bonds with a minimum issue size of $500 million and at least three years to maturity – mimic the broader market as illustrated by the breakdown of the liquid investment grade market across ratings categories (shown in Exhibit 1).

Exhibit 1: IG credit spreads by Moody’s rating category

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities; Note: Indices are constructed from bonds in as represented in the BlackRock iShares exchange traded fund LQD. Market values  are based on par amounts in the LQD index and are as of close 11/15/2016. The credit spread is calculated as the market value weighted spread to the Treasury curve, or g-spread. The yield and maturity are also market value weighted averages. Complete inclusion criteria for the LQD index is available on the iShares website. There are also some cash and money market holdings in LQD which is why the index weights don’t sum to 100%.

A small subset of bonds in the index are rated high yield by Moodys, but those typically retain investment grade ratings from either S&P or Fitch. Not surprisingly, the market is ahead of the ratings agencies, and those bonds straddling investment grade and high yield have materially wider spreads – 230 bp on average versus 173 bp for Baa. A recent history of the credit spreads across ratings categories (shown in Exhibits 2 and 3) indicates that although all ratings categories have experienced spread widening on a nominal basis this year, there has been an acceleration in the gap between A-rated and Baa-rated debt over the last few weeks.

Exhibit 2: One-year history of credit spreads across ratings categories

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities. Note: Credit indices are constructed from bonds in the LQD index, as a market value weighted average of the g-spread from Bloomberg. Any bond with less than 90 days of spread history is not used.

The sharp move wider in recent days is consistent across ratings categories, but the difference in Aa and A-rated bonds has not changed; the widening in Baa-rated debt has been quite sharp.

Exhibit 3: One-year history of credit spread changes between ratings categories

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities.

Leverage and momentum

The push wider over the last several weeks – exacerbated over the last few days – was punctuated by weakness in two heavily indebted Baa names: Ford and GE. This has led to some contagion risk across other highly levered names which face structural business challenges and are struggling to reduce their debt loads. None of this volatility is based on current economic weakness. There are legitimate fears that there could be a waterfall of downgrades from investment grade to high yield should the economy stumble into a recession, but this does not appear to be an imminent danger. High levels of leverage leave any balance sheet with less room to maneuver. For now, many highly leveraged companies hope to earn their way out of the problem and reduce leverage through profitability. Slowing growth could force companies instead to reduce share buybacks or cut dividends in order to deleverage. Debt spreads may continue to widen until the market sees clear evidence that management is willing to put debtholders ahead of shareholders.

Momentum is not a trivial force in the markets, and the re-pricing of credit may broaden to other vulnerable Baa names. Over time larger spread gaps could develop between names and rating categories as investors discriminate among the idiosyncratic risks embedded in particular corporations and business models.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles