The Long and Short
Focus on names dancing on the debt ceiling
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.
With the debt ceiling looming over the markets, investment grade credits with the most exposure to government contracts should come into focus. These credits have the most to lose should negotiations break down and the current debt ceiling remain in place. While aerospace and defense contractors have some of the most exposure, there are a handful of healthcare and pharmaceutical credits with a significant percentage of premiums derived from Medicare and Medicaid contracts or significant revenues from government reimbursements. Other sectors such as building materials and waste management are exposed through a variety of sub-contractors. The company with the most exposure, Leidos Holdings Inc. (LDOS), falls in the technology sector. However, LDOS’ largest customers include the US Department of Defense, the US Department of Homeland Security, the Federal Aviation Administration and a variety of state and local government agencies.
Although most of the market has focused on the US ability to service its debt without a lift in the debt ceiling, all government programs could see a delay in payments due. This is particularly true with a government running a deficit, which the Congressional Budget Office in February projected at $1.4 trillion for fiscal 2023. That budget includes payments to Social Security, Medicare and Medicaid, the military, veterans, defense contractors and others. If the federal government cannot borrow, it cannot make projected payments.
Any shortfall in government payments should fall most heavily on credits with a significant share of revenue derived directly or indirectly from government programs (Exhibit 1). The longer the debt ceiling stays in place, the bigger the impact. Of course, a much broader set of credit would likely feel the impact from a sharp contraction in fiscal spending.
Exhibit 1: Selected IG credits with US government contract exposure
Source: Company 10Ks, Bloomberg; Santander US Capital Markets
The year-to-date equity performance of most credits heavily exposed to government spending shows some material equity deterioration. Although, a couple of outliers remain including Humana Inc. (HUM) and the Boeing Company (BA). HUM is expected to benefit this year from strong Medicare enrollment as Baby Boomers are expected to drive this tailwind through the end of 2029. However, that growth could put pressure on spreads if Medicare payments are delayed. BA, on the other hand, has been on a huge recovery trajectory after making a comeback from the 737 Max crashes in 2018 and 2019. Most recently, BA won a significant order from Ryanair, for up to 300 737 Max jets valued at $40 billion.
Both building materials and waste management companies also have witnessed strong equity performance year-to-date. Companies that specialize in aggregates, including VMC and MLM have witnessed solid growth this year largely from pricing actions. Aggregates are also expected to benefit from the Infrastructure Investment and Jobs Act, which will expand federal highway spending by nearly 60% by 2026. While neither company has direct government exposure, roughly 40% to 55% of their aggregate shipments are used in publicly funded construction projects. Waste management companies have long been viewed as a recession resistant sector, which has supported performance this year. However, government exposure rests with the multitude of municipalities that they serve.
REIT equity performance has largely been positive. However, REITs with the largest exposure to skilled nursing facilities have the most exposure to government reimbursements. While spread performance in the REIT sector has been pressured due to the current interest rate environment, healthcare REITs could face even further pressure as the debt ceiling looms.
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