The Long and Short
IG finally posts a positive return in May
Dan Bruzzo, CFA | June 3, 2022
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.
The investment grade corporate bond index posted its first positive total return of the year in May, as rates fell modestly and credit tightened off a local wide. Despite more than $20 billion in outflows from US investment grade bond funds, spreads on the IG index managed to tighten by 8 bp in what appeared to be a very distinct flight-to-quality in credit. It was enough to generate a 0.93% total return and 0.63% excess return for May, despite continued selling in the first three weeks of the month.
Off the May performance, Amherst Pierpont is making a few changes to sector relative value views. Utilities and natural gas segments move to undervalued from overvalued, while technology and consumer-cyclical segments move to overvalued. The two graphics below provide a summary of Amherst Pierpont expected excess return across sectors—total return net of Treasury hedges—within the IG Index for the next several months. These suggestions serve as a proxy for how portfolio managers should position their holdings relative to the broad IG corporate bond market. The relative value recommendations consider a 6-month horizon.
Exhibit 1 and 2. APS Sector Recommendations for June 2022
With the current pace of inflation not seeming to slow anytime soon, retailers must look at further price hikes to offset the spike in energy and transportation costs while managing wages. Recent wage increases have hit margins and if inflation continues at the current pace, further wage increases may be necessary in order to retain employees. This will likely lead to further margin deterioration as the year progresses and the possibility of more downward revisions to guidance. After the risk-off trade witnessed with the latest round of retail earnings, we felt it was necessary to deem the consumer cyclical sector as overvalued.
Despite being flush with cash, technology companies that rely heavily on M&A for growth will be forced to pay more if financing their acquisitions with debt. The use of equity as currency seems unlikely given that the Nasdaq is down nearly 23% year to date. Additionally, supply chain constraints have exacerbated chip shortages which means that meaningful top line and profit growth is unlikely to come to fruition this year. The weakness in the equity market has leaned on credit spreads in this sector, despite the majority of technology balance sheets being very much in shape. As such, we believe the sector remains overvalued and likely to witness further widening as the year progresses and interest rates rise.
In May, safer credits were favored by investors in the credit recovery. As a result, the top performing sectors were communications (1.54% excess return), consumer non-cyclical (0.87%), technology (0.85%), utilities (0.82%), and transportation. The top performance in the communications sector was aided by the AT&T tender offer that took place during May with the proceeds from the recent WarnerMedia spin-off debt launch back in March. Higher risk segments of the market struggled to participate in the recovery, as investors maintained their distance from higher beta credits that have experienced the worst of the recent sell-off. In particular, finance companies (-0.27%)—with concentrations in middle-market direct lenders and aircraft finance companies—continued to significantly underperform the broader IG market. Also among the bottom performances in May were REITs (-0.50%), brokers/asset managers (-0.11), natural gas (0.14%) and capital goods (0.15%).
The USD investment grade new issue calendar moderately underperformed expectations in May with $93.5 billion in total volume for the month, but with frequent delays and postponements from issuers the final total seems like it could have been a lot worse – particularly given that the final week of the month was a total washout. Issuers were persistent on days that new issue was functioning. There were just three jumbo debt launches contributing to the monthly total, led by Intercontinental Exchange’s (ICE: A3/A-) $8 billion debt launch to fund a merger announcement from just days earlier. Issuers are not waiting around to bring their merger funding packages to the market given all the trepidation around rates and the trajectory of credit. Better to issue today with special mandatory redemption language than wait around and risk much higher borrowing costs, or worse yet a new issue calendar that cannot accommodate your issuance needs. High yield primary markets were nearly non-existent adding just $5.0 billion to May’s total gross supply. Banks made up the bulk of the primary calendar at over 40% while the ICE deal pushed broker/asset managers to nearly 13% of the IG calendar.
Exhibit 3. Gross and Net Supply Recap
Exhibit 4. Mutual Fund Flows
Exhibit 5. New Issue by Sector
Exhibit 6. New Issue by Rating
Exhibit 7. New Issue by Tenor
Exhibit 8. Flight to quality favors communications, consumer, tech, and utilities
Exhibit 9. The late month recovery in credit was very much a flight to quality
Exhibit 10. Long-dated paper benefits as treasuries rally off the wides
Exhibit 11. KSS spreads continue to spike on takeover speculation, business development companies (BDCs) continue to be among the bottom performers
Dan Bruzzo, CFA
1 (646) 776-7749