The Big Idea

Out-of-consensus calls on corporate credit in 2024

Dan Bruzzo, CFA and Meredith Contente | November 17, 2023

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.

Supply, M&A, the power of cash on a balance sheet, the performance of technology credits, the play in regional banks and consumers’ continuing willingness to spend in some areas all look like areas where the market may find unpriced opportunity through the coming year. All of this plays out against a background where even investment grade credits will have to navigate tight conditions in debt markets.

Our out-of-consensus calls for the year ahead:

• Gross supply remains flat despite expectations for a sharp drop
• M&A returns to North American packaged food
• Cash rich balance sheets offer defense against rising borrowing costs
• Technology should outperform again as balance sheets are stronger
• More regional bank failures look like a low probability for 2024
• Consumer will still spend on leisure travel

Gross supply remains flat despite expectations for a sharp drop

Gross volume for the US investment grade corporate bond market currently looks likely to close out the year in the $1.20 trillion to $1.22 trillion range. This would be a slight downtick from the prior year’s $1.25 trillion, which is not altogether surprising given the surging rates and anemic M&A of 2023. While it is still early to get a strong sense of what the consensus for gross supply in 2024, many estimates will likely look for a material drop. While it is apparent that the rate environment is poised to potentially keep some of the more opportunistic issuers sidelined for at least the earlier portion of the year, the first out-of-consensus call for the coming year is that the actual primary market volume will remain relatively flat to the results in 2023 (Exhibit 1).

Exhibit 1: Investment grade annual USD issuance

Source: Santander US Capital Markets LLC, Bloomberg LEAG tables

While the 5-year average for investment grade gross issuance is around $1.46 trillion, that figure is heavily skewed by the outsized results for the market in the pandemic-influenced years of 2020 ($1.91 trillion) and 2021 ($1.51 trillion), when government back-stopping and rabid demand for spread product amidst artificially low rates pushed volumes considerably higher. Recent non-pandemic years have mostly remained in a fairly tight band between $1.22 and $1.23 trillion (Exhibit 2). Next year’s total is likely to land on the lower end of that range, very close to where 2023 is projected to finish.

Exhibit 2. This year is on pace approach 2018, 2019 and 2022 gross volumes

Source: Santander US Capital Markets LLC, Bloomberg LEAG tables

When making an estimate for gross volume it is important to gauge the amount of debt rolling off in the next several years. A 3-year cumulative look forward can provide a good view for how active issuers might be in the coming twelve months, even as rates threaten to potentially keep “cash rich” issuers on the sideline, who might opt instead to allow net debt to roll off their balance sheets. As of the end of 2023, investment grade issuers will have just under $3 trillion in debt maturing within the next three years. That represents around an 8% increase over the forward look from year-end 2022, which was around a 9% increase over the prior year. Therefore, even if there is an expectation that opportunistic and/or M&A related debt issuance will decline by as much as 5% to 10%, there is just as much additional debt scheduled to roll off corporate balance sheets in the very near term that could need to be accounted for. These factors could keep overall gross issuance levels pretty flat relative to the current year, even if net supply would be poised to drop under those circumstances. Global M&A volume measured in US dollars dropped 33% in 2023 to $3.01 trillion so far from $4.50 trillion in the previous year and is down 55% from a recent peak of $6.66 trillion in 2021. Even if there is some recovery, those M&A volume figures are likely to remain constrained in 2024 as materially higher rates present more challenging borrowing hurdles for potential growth opportunities within most corporate sectors—although we see capacity for higher M&A in the consumer space, specifically packaged food.

Exhibit 3: Three-year cumulative projected maturities for 2023 are up 8% YoY

Source: Santander US Capital Markets LLC, Bloomberg LEAG tables

M&A returns to North American packaged food

As the consumer has stayed relatively resilient through 2023, cracks in the health of the consumer are starting to become more visible. Persistent inflation in 2023 has weighed heavily on both discretionary and non-discretionary purchases. North American packaged food, which has been a beneficiary of the pandemic and subsequent lockdowns, managed to post solid growth over the past few years. The first round of growth came from increased volumes once the pandemic started and the second round due to pricing measures to offset increased input costs.

Despite largely positive organic growth this year, price increases have begun to moderate, with declining volume signaling that consumers are having trouble digesting the increased costs. Consumers have looked to private-label for price relief relative to national brands, in an effort to make food budgets stretch. That said, it’s unlikely that packaged food companies will have the capacity for further price increases without being met with further volume declines.

Exhibit 4: North American packaged food volume performance (1Q19-3Q23)

Source: Company reports, Santander US Capital Markets

North American packaged food companies have largely witnessed equity declines this year, with the exception of Mondelez International (MDLZ: Baa1/BBB). On a combined basis for North America packaged food credits, equity performance is down approximately 20% year-to-date (Exhibit 2). Even with increased dividends and a return to share buybacks, after being halted post the last largest round of M&A activity (which occurred in 2018), equity prices continue to fall. In fact, since the start of 2018 to now, equity prices for the combined group have increased 1.5% and have underperformed the S&P 500 Consumer Staples Index by roughly twenty-five percentage points. MDLZ and The Hershey Company (HSY) were the only credits to outperform the equity index over that time period. The pressure for management teams to improve equity performance is mounting.

Exhibit 5. North American packaged food equity performance (1/1/23-YTD)

Source: Bloomberg, Santander US Capital Markets

To return both equity and volume to a positive growth trajectory, the packaged food sector will likely resume M&A activity despite the higher interest rates. Balance sheets are largely back in order, as strong cash flows derived from the pandemic enabled management teams to rapidly repay debt associated with the last round of M&A activity ahead of projected timetables. Based on the aforementioned equity and volume performance, the most likely candidates that will look to participate in the next round of M&A include: General Mills Inc. (GIS), Conagra Brands Inc. (CAG), Kellanova (K), The Kraft Heinz Company (KHC) and Campbell Soup Company (CPB). MDLZ and HSY has managed to post both equity and volume growth while The JM Smucker Company (SJM) just completed the acquisition of Hostess Brands.

Cash rich balance sheets offer defense against rising borrowing costs

While the consensus approach for investors in 2024 may be chasing lower-rated credit, bondholders would be better served to target industries and individual credits with high cash balances relative to their debt burdens. The rising rate environment poses one of if not the single biggest challenge to corporate credit in the coming years, as sizable maturity walls require many issuers to refinance large portions of their debt balances at considerably higher interest expense. In turn, those issuers could see leverage and interest coverage metrics stressed in the near-term leading to potential downgrades, particularly at the lower end of the credit spectrum and among companies with limited liquidity on their balance sheets to be selective about when and how much they choose to issue.

In order to quickly summarize where investors should be targeting allocation in 2024, the following graphic provides a view of current cash balances at all non-financial subsectors relative to the current debt burden on their balance sheets. The industries that score above the study total of 25% are an indication that they may be in better position to be more selective about re-issuing debt in the near-term, or even consider allowing debt to roll off the balance sheet altogether. There are some unsurprising segments scoring near the top end of the range, such as Technology (41%), Media (60%), Aero/Defense (64%) and Rails (63%). Meanwhile, there are others that appear to be more cyclical/seasonal industries benefiting from their current position in the cycle (Chemicals, Metals and so on).

Exhibit 6: Current cash balances relative to total debt on balance sheet

Source: Santander US Capital Markets LLC, Bloomberg LP, company filings, index constituents chosen on basis of bonds outstanding and data availability

On a relative value basis, investors can weigh those balance sheet criteria against how spreads in each subsector are currently performing relative to their recent history (Exhibit 7). Furthermore, recent analysis largely favors the selection of ‘A’ credits relative to either ‘AA’ or ‘BBB’ based on historical relationships between the broad rating categories, which makes a case for a more defensive posture on balance sheet liquidity as investors look toward the new year.

Exhibit 7: Current OAS versus 5-year trading range in percentile rankings

Source: Bloomberg, Santander US Capital Markets

Technology should outperform again as balance sheets are stronger

With interest rates remaining high and the potential for them to stay at current levels for most, if not all, of 2024, credits with strong cash balances should be in the best position to outperform. While equity analysts are calling for the technology equity bubble to burst, there should be little risk to technology spreads given the health of the balance sheets. The strong balance sheets allow for debt repayment versus refinancing at disadvantageous rates. Furthermore, it supports reinvestment in the business to fuel innovation and growth. There are a handful of IG technology credits that remain in a sizeable net cash position while others have cash balances that largely outweigh debt maturities in fiscal 2024.

Exhibit 8: IG technology balance sheet highlights

*Excludes Operating Leases
Source: Company Reports; Bloomberg; Santander US Capital Markets

These liquid balance sheets can be viewed as a defensive play particularly if the consumer were to curb spending given the continued inflationary pressures. While an economic slowdown would likely impact growth, technology balance sheets could withstand that pressure without any headline risk associated with liquidity concerns. These names boast some of the strongest free cash flow conversion rates, with the majority posting FCF/sales above 20% (Exhibit 6). On a combined basis, FCF/sales stood at 23.1% for 2024 based on consensus estimates for revenues and free cash flow for the year. The strong free cash flow provides significant financial flexibility for these credits. Furthermore, it supports the potential for cash balances to continue to expand further in 2024.

Exhibit 9: 2024 IG technology free cash flow conversion estimates

Source: Company Reports; Bloomberg; Santander US Capital Markets

On a combined basis, cash balances for the aforementioned credits increased by nearly $71 billion year-to-date in 2023. Combined these credits have a total of $655 billion of cash on hand which compares to $524 billion of total debt. Of the thirteen credits listed, only six tapped the debt market this year. Meta Platforms Inc. (META) was the one credit that was opportunistic and tapped the market despite having no maturing debt. The proceeds were earmarked for general corporate purposes with a priority for reinvestment in the business and to repurchase shares. International Business Machines Corp. (IBM) and Dell Technologies Inc. both issued debt that was in excess of maturities. Combined, debt issuance totaled nearly $33 billion for the year relative to $26 billion of maturities. Absent META’s $8.5 billion debt launch, debt maturities would have exceeded issuance (Exhibit 7).

Exhibit 10: Debt maturities relative to issuance (2023)

Source: Company reports, Bloomberg, Santander US Capital Markets

The relative lack of issuance helped spread performance this year as there was no forced selling ahead of issuance and no real spread concession risk. Should technology credits once again look utilize their strong cash balances to repay debt versus refinancing, technology spreads should outperform. Furthermore, technology equity valuations are at some of their highest levels, limiting the need to repurchase shares to help prop up the stock price. Broadcom Inc. (AVGO) is the only credit that we anticipate to tap the primary market in the near term as it looks to close on its acquisition of VMWare (VMW). The deal is anticipated to close by the end of November 2023. AVGO recently replaced its $32 billion bridge facility with $28 billion of term loan commitments, suggesting that AVGO will use less debt financing than previously forecast due to its strong cash flow generation this year.

More regional bank failures look like a low probability for 2024

The US regional banking crisis in spring of 2023 was arguably the most relevant event to impact domestic credit markets for the entire year. The respective collapses of Silicon Valley (SIVB), Signature Bank (SBNY), and First Republic (FRC) triggered a sell-off in domestic bank credit and it took most of the remaining year for spreads to recover. Nevertheless, at current valuations, credit spreads of domestic regional banks appear to still be pricing in the prospect of another round of small-to-mid-sized regional bank failures and/or related contagion/fallout. Despite this consensus valuation of bank credit spreads at riskier levels, another round of bank failures appears a very low probability type of event to resurface in 2024 given the anomalous nature of the banks that failed in spring ’23 and the stability of remaining bank balance sheets (Exhibit 11). As far as M&A, it seems likely that there will be reluctance to initially participate until the market begins to acknowledge the stability of the industry. While broad consolidation seems to be an eventual inevitability for smaller-to-midsized players in the US banking industry, early 2024 is unlikely to see a meaningful number of these deals materialize.

Exhibit 11. Banking at 80% of historical trading range appears to be pricing in prospect for further sector dislocation

Source: Bloomberg, Santander US Capital Markets

As we look back at some of the characteristics that contributed most to the concerns that triggered SIVB, SBNY and FRC, there begins to be a disconnect with most of the remaining banks within the industry, in particular those with solidly investment grade credit profiles. Banks with California footprints were quickly drawn into the fray as SIVB was the first among the three to trigger concerns throughout the industry (and FRC shortly thereafter), but SBNY proved that the criteria for concern was not strictly a West Coast phenomenon.

The rising rate environment in late 2022 and early 2023 very quickly created an issue for the large, long-duration securities holdings that some banks had been stockpiling throughout the years of extended low rates in their held-to-maturity (HTM) as well as available-for-sale (AFS) portfolios. As rates began to turn, the unrealized losses very quickly began to run up. Consider SIVB’s holdings just prior to collapse. SIVB’s total securities holdings stood at over 55% of their total assets. Meanwhile, the nearly $18 billion in total unrealized losses in the securities portfolio just prior to collapse represented 149% and 129% of Tangible Common and Tier 1 Common Equity, respectively. Even regional banks that are still considered vulnerable to securities losses are not even at half those thresholds as SIVB was when its survival became untenable by market standards.

As the banking crisis began to take shape, investors quickly began looking at deposit concentration, with concerns that a repeat of SIVB could occur with a large portion of depositors seemingly disappearing overnight. SVB Financial was a unique institution. Because of its position as a lender to the venture capital industry, an estimated 97% of the bank’s total deposits were uninsured as of year-end 2022. That resulted in an average deposit size in excess of $1 million, the largest in the entire industry. SBNY’s average deposit size was the next largest among US banks at roughly $500 thousand. Western Alliance Bank (WA) was next at about $300 thousand, with FRC following just behind it at just over $200 thousand. After that the range of deposit size dropped off dramatically. Among more typical regional banks with reasonably high concentration in commercial depositors, the average deposit size typically falls more closely to the $30-60 thousand range, while the industry median for uninsured deposits lands closer to the low-50% area, demonstrating the anomalous nature of the banks that eventually became subject to FDIC intervention.

While not a pre-cursor to the spring 2023 regional bank crisis, another factor that has been raising concerns across the US banking industry in wake of the three collapses is the degree to which commercial regional banks are highly concentrated in commercial real estate (CRE) lending. CRE in the US has long been speculated as a potential area for rapid credit deterioration in the near-to-intermediate term. Regional banks have done a commendable job in recent quarters increasing their disclosure of the riskier aspects of these exposures, in particular some of the dicey corners of office lending. While those disclosures have varied, the general takeaway from the last few quarterly reporting periods is that the bulk of the IG regional bank sector appears well diversified from a pending crisis in the CRE segment, which itself appears a long shot for calendar 2024.

Consumer will still spend on leisure travel

With discretionary consumer budgets getting squeezed by stubborn inflation, there remains pockets that the consumer will continue to be willing to spend on. One such area is leisure travel. The travel industry has rebounded considerably since the pandemic trough witnessed in 2020. Online travel companies are now witnessing revenues and EBITDA that exceed pre-pandemic levels. Despite the concern that this is one of the easiest discretionary categories to cut from while budgeting expenses, the consumer is likely to not give up leisure travel anytime soon. Wars waging in the Middle East and Russia and the increasing cost of travel (up 19% since May 2019) are no match for a consumer that lost roughly two years of vacation time as COVID spread rapidly and globally.

The components of leisure travel have not all grown at the same rate. In fact, flights have seen the least growth in price relative to other travel components such as hotels and car rentals. According to the U.S Bureau of Labor Statistics rental car prices increased 48% over the four-year time period from May 2019-May 2023. This compares to a 15% and a 5% increase in hotels and flights, respectively, over the same time period. In order to make travel budgets work, the consumer may shed a car rental and opt for public transportation, especially in urban areas where public transportation is easy to navigate and is typically the primary mode of transportation for residents.

Exhibit 12: Car rental prices percent change versus 2019

Source: U.S. Bureau of Labor Statistics

The clear IG beneficiaries of the insatiable demand for leisure travel are Booking Holdings Inc. (BKNG: A3/A-) and Expedia Group, Inc. (EXPE: Baa3 (p)/BBB/BBB-(p)), given their ability to bundle travel components on one site. The hotel credits, including Marriot International (MAR – Baa2/BBB), Hyatt Hotels Corp. (H: Baa3/BBB-/BBB-) and Choice Hotels International Inc. (CHH: Baa3/BBB-(*-)) will also benefit but not to the extent as the online travel companies. Not only can you book flights, cars, and hotels through the online travel companies, but they also provide the ability to book alternative accommodations (i.e., apartments and houses) which can be cheaper than a hotel while accommodating more people. In fact, BKNG noted on its last earnings call that alternative accommodation room nights grew faster than the traditional hotel category. It also alleviates the need to book an alternative accommodation through sites such as Airbnb, Inc. (ABNB). (Vrbo, ABNB’s largest competitor, is owned by EXPE.) These “travel bundles” provide for more attractive pricing for the consumer, which could be a deciding factor when booking leisure travel.

Drilling down further, the online travel companies maintain stronger balance sheets than their hotel counterparts, underscored by large cash positions. These strong cash positions provide for financial flexibility and liquidity should the consumer curb leisure travel spending, while keeping net leverage very low.  BKNG has maintained a net cash position since fiscal 2008, while EXPE’s cash balance grew by nearly $1.0 billion over the past year while management has been focusing on debt repayment. In comparison, the hotels maintain minimal cash balances.

Exhibit 13: Credit highlights (LTM 9/30/23)

*Excludes Operating Leases
Source: Company Reports; Bloomberg; Santander US Capital Markets