Out-of-consensus calls on corporate credit in 2025

Dan Bruzzo, CFA | November 22, 2024

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.

As in other parts of US fixed income, a new administration in Washington, DC, looks set to create change in the investment grade corporate market. Not all of it is priced in. That opens up a few clear opportunities for investors. In particular, investment grade spreads should remain at historically tight levels, the banking sector should continue to outperform and some of the leaders in the auto industry should add excess return.

Investment grade spreads remain at historically tight levels

Despite widely held beliefs that investment grade spreads cannot hold at historically tight levels, elevated all-in yields and investor demand that outstrips supply should support these valuations for 2025. Corporate bond investors can increasingly hit yield bogeys despite historically tight spreads. There is also precedent for spreads remaining tight, with the investment grade index at or below 100 bp in OAS for multi-year stretches while Treasury rates are elevated or rising, and while benign credit conditions remain supportive (Exhibit 1).

Exhibit 1: Corporate spreads have dropped below 100 OAS for long stretches

Source: Bloomberg LP, Santander US Capital Markets LLC, Bloomberg US Aggregate Corporate OAS

Furthermore, given the rapid tightening of SOFR swaps relative to US Treasuries, corporate bond investors are increasingly comparing credit spreads to the SOFR curve as opposed to a traditional Treasury benchmark, providing at least some degree of debate as to whether spreads are actually valued at historic tights from a practical standpoint. This has been further facilitated as we have moved back to a more normalized yield curve over the past year (Exhibit 2).

Exhibit 2: US Treasury and corporate bond curves normalized over the past year

Source: Bloomberg LP, US Treasury Actives and US Corporate IG BVAL Yield Curves

With the US elections freshly in mind, there are myriad political implications that the Republican victories in the executive and legislative branches could have on corporate bond spreads, many of which support spreads remaining tight or grinding even further throughout 2025. The impact of US Treasury supply from increased deficit spending is optically favorable toward nominal spreads overall. Meanwhile, the prospect of additional tax cuts could also provide a significant potential positive effect for credit, as corporate creditors would in theory have more discretionary cash flows available for either debt reduction or growth if new corporate tax cuts were quickly approved throughout 2025. Potentially offsetting these factors is the degree to which more protective tariff policies, coupled with a shrinking labor supply due to more aggressive immigration policy, could both have inflationary pressures on pricing. Typically, a more inflationary environment could lead to a more “risk off” posture toward credit. Furthermore, a weaker dollar could also soften global demand for US dollar-denominated corporate bonds from international institutional investors.

Also offsetting the positive factors on credit could be the deregulation of key corporate industries, which in theory could open up opportunities for mergers and acquisitions. Increased M&A activity could rapidly raise the supply side of the equation for US investment grade corporates. M&A activity has remained very low in 2024 for a second consecutive year, despite investment grade new supply reaching the second highest cumulative total in history (Exhibit 3 and 4). Early predictions for supply in 2025 suggest that many market participants are anticipating a similar showing, if not slightly more, than what was recorded in the current year. Projected maturities for index-eligible, investment grade corporate bonds are around $982 billion for 2025. Predictions for new supply could be boosted even further if the incoming administration scales back regulation in key industries such as TMT, consumer, and banking, allowing for more consolidation among market participants. More deals in theory could spur more debt funding even as rates remain elevated over recent periods of heightened M&A activity.

Exhibit 3. This year has seen the second most issuance in recent history

Source: Bloomberg LP, LEAG Tables

While this factor warrants monitoring over time, instinctively it seems more likely that in the initial year under the new administration that M&A activity would remain in a similar range to the two previous years, more influenced by rates than policy. Greater deal activity with deregulation would likely take longer to manifest noticeable results. This is especially true in segments such as domestic banking, where even an accommodative regulatory environment that is conducive to more deal announcements still could take a tremendous amount of time before the deals actually begin to get approved and materialize. Furthermore, consolidation among banks is not particularly among the sectors likely to have a substantial impact on corporate bond supply. Those deals are far more likely to carry a much larger equity funding component due to regulatory capital requirements, as regulators would not approve a highly levered merger among regulated regional banks (see bank section for more discussion on the impacts of de-regulation).

Exhibit 4: Global M&A volume and deal count

Source: Bloomberg LP

Meanwhile, the demand side of the equation give significant support to corporate credit valuations. Mutual fund flows into investment grade credit have been remarkably consistent over the past year, with only seven total weeks of outflows so far in calendar 2024 (Exhibit 5). Again, higher all-in yields with the rise in rates over the past year has bolstered demand and help make investment grade corporates a preferred asset class amongst global fixed income investors.

Exhibit 5: Only seven weeks of outflows for investment grade bond funds in 2024

Source: Bloomberg LP, Lipper

The Banking sector has room to continue to outperform in 2025

An overweight in the banking sector has served most portfolio managers well through much of 2024 as negative perceptions about the industry have been gradually abating since the peak of concerns in spring of 2023. Banks are some of the few credits in the investment grade index that could maintain some semblance of upside relative to their historic ranges as credit continues to test all-time tights levels relative to US Treasuries. In particular, some of the higher beta US regionals appear to offer attractive relative value to the broader field of investment grade credit compared to US money center banks that are increasingly being priced highly competitively.

Expect the Big Six US banking institutions to seek to meet their issuance needs early and often in the early quarters of 2025. Furthermore, there could be a significant wave of subordinated Tier 2 debt issuance with some of the bigger pieces of that capital structure moving their way deeper into phases of amortization. It would make sense that banks use tight credit spreads overall to re-issue some of those debt deals from the mid-to-late 2000-teens and rebuild those levels of their capital structures. Moving down in structure can provide investors opportunity for further outperformance in the segment.

Year-to-date, banking has been a Top 6 performer within the investment grade index when calculating sector performance by credit or excess return (returns net of commensurate Treasury returns). The excess return so far in 2024 has been 3.12% with a total return 4.60%, which is among the top three within the index when taking into account the impact of rates (Exhibit 6). Comparatively, the entire investment grade index has generated an excess return of 2.70%, with a total return of 2.59%. Utilities and financial segments of the index have provided the best returns to portfolio managers overall year-to-date.

When looking at the opportunity set available to corporate bond investors moving forward, overall valuations moving to historic tights has made it increasingly difficult to project much by way of potential outperformance (Exhibit 8). The investment grade index has been trading at an OAS of less than 80 bp since earlier this month and has hit as low as 73 bp in the days following the election. Nevertheless, when looking at where current spreads stand versus the 5-year range of trading, or the percentile ranking, more than ever this demonstrates that only a few areas of the market are trading wide of their 5-year historic tights. This analytic typically serves as an overvalued/undervalued indicator for corporate bond investors relative to the 5-year trading range of credits within each sector. The single highest ranking of these sectors is in banking, which is currently at the single widest level of 14% of the 5-year range (Exhibit 7).

Exhibit 6: Investment grade corporate index sector returns year-to-date

Source: Santander US Capital Markets LLC, Bloomberg LP, Bloomberg index sector credit returns

The new Trump administration could once again have significant impact on the domestic banking industry, several of which were previously observed during the first administration. Most notably, deregulation and rolling back certain elements of the Dodd-Frank act are generally viewed as positive to earnings and profitability among banks. The same can be said for lower overall corporate tax rates. This de-regulation could be particularly impactful with regard to aspects of the Consumer Financial Protection Bureau as well, which could loosen controls and afford more flexibility to the banks to offer loans and products at the consumer level that had previously been limited by more stringent application of the rules. Worth noting is that while many of these aspects are perceived as positive from a shareholder’s perspective, the same is not always true for creditors. For example, if banks are afforded the flexibility to carry lower levels of regulatory capital, enabling them to repurchase more shares. Clearly, that’s a positive for stocks, but the end result is weaker credit protection for bondholders, and eventually potential downgrades if it were to persist.

Exhibit 7: Investment grade corporate sector spread 5-year percentile rankings

Source: Santander US Capital Markets LLC, Bloomberg LP, Bloomberg corporate sector indices

The other aspect of de-regulation that had previously been introduced is the potential for greater M&A activity. It seems unlikely that there will be a significant wave of consolidation among US regional banks, at least in the first year of looser regulations. Regardless of looser application of existing regulation, regional banks that might consider a sizable merger with a competitor must contemplate the risks of potentially moving up to a higher regulatory category among banks, which might make them reluctant to do so. And, even with a more likely path to completion, those mergers could be held up in the approval process for significant periods of time before the market actually sees any kind of meaningful impact. Lastly, the prospect for substantial debt funding that could influence the market also seems like a less likely outcome of increased consolidation, as regulators are not likely to approve deals that come with a sizable debt component of funding.

Exhibit 8: Investment grade regional banks still appear relatively attractive

Source: Santander US Capital Markets LLC, Bloomberg LP, TRACE/BVAL G-spread indications only

Over the past roughly two years, chief concerns among investors for the US banking industry have shifted as new challenges have arisen, but all have contributed to wider valuations relative to the broad investment grade index. Back in the spring of 2023, as rates were steadily rising, the industry became highly aware of large potential unrealized losses held in the banks’ held-to-maturity and available-for-sale securities holdings, as the banks had been overextending their collective appetites for duration throughout the prior period of extremely low rates. Banks have been working through those exposures, and even those regional investment grade issuers with still significant unrealized losses appear manageable relative to capital holdings.

Shortly thereafter, the collapse of Silicon Valley and Signature Bank and the rescue of First Republic put emphasis on deposit stability and the risk of deposit flight. After those concerns eventually abated, the issues at New York Community Bank in early 2024 put a spotlight on commercial real estate exposures with concerns about a potential bubble among lenders. While those concerns remain, particularly for smaller lenders with larger CRE concentrations, the focus more recently has been on the Fed. Specifically, how the evolving rate environment will impact net interest income and net interest margins with highly competitive deposits weighing on profitability. However, in more recent earnings results, the bigger banks have demonstrated relative stability even as management teams have warned about the environment for net interest income going forward.

Ford and GM provide an opportunity for above-average performance

Year-to-date, the automotive subsector (within the consumer cyclical sector) has recorded excess return of 2.28% and total return of 4.19%. That credit return for autos fell below the index average of 2.65% but is poised to finish well above the index total return of just 2.75% for the year so far. Meanwhile, current spreads are at 23% of their 5-year range (percentile rank), which makes autos the single widest trading subsector among all non-financial categories (Exhibit 9). The opportunity set of the auto credit curve has tightened substantially over recent weeks with the broader market, but still provide the opportunity for above average performance with strong relative value in Ford (F: Ba1/BBB-/BBB-) and General Motors (GM: Baa2/BBB/BBB) in 2025 (Exhibit 10).

Exhibit 9: Industrial subsectors’ current spread 5-year percentile ranks

Source: Santander US Capital Markets LLC, Bloomberg LP, Bloomberg index sector credit returns

As with the banking sector, the policies of the new administration could have significant impact on operating performance for domestic autos going forward. Recent and ongoing rate cuts and therefore potentially lower borrowing costs should provide a better environment for top-line performance in the near to intermediate future for the domestic OEMs and their respective financing arms. Perhaps generating the most attention is the prospect for protective tariffs that can have various impacts on both Ford and GM. On the negative front would be the degree to which tariffs could significantly raise production costs with raw materials coming from abroad, specifically steel and aluminum. Higher expenses could cut into already pressured profit margins for the OEMs. Furthermore, retaliatory tariff policies abroad in China and Europe could have material impact on sales outside of the US. GM has considerably more exposure to the market in China than Ford does, as the region accounts for over 30% of international sales (which are about 19% of sales overall).

These negative factors would be potentially offset by the degree to which the protective measures are actually successful in bolstering sales at home and allowing the domestic operators to compete more aggressively on price with their foreign competitors. It remains to be seen the degree to which actual tariffs will be imposed as opposed to being used primarily as a bargaining technique abroad as many are projecting. Lastly, there is a lot of speculation about the administration’s environmental policies and how they might impact the continued push into electric vehicles. More relaxed policies could benefit Ford and GM as they have struggled to increase uptake and achieve profitability in their respective EV segments, while maintaining more successful results in their ICE and hybrid vehicles. The automakers have already been scaling back and delaying capacity in EV and more relaxed environmental policies could afford them more flexibility to do so, which would enable them to term out into a more gradual phase-in period than they have been pursuing over the past several years.

Exhibit 10. Investment grade automotive credit curve

Source: Santander US Capital Markets LLC, Bloomberg LP, TRACE/BVAL G-spread indications only

Underlying strength in F’s credit profile in the form of low leverage and strong liquidity at the motor company provide a lot of potential cushion against near-term operating weakness, and could see a move to full investment grade ratings with an eventual upgrade by Moody’s in the not too distant future. This makes F the greater opportunity between the two domestic OEMs in the corporate bond market. Margins remain pressured by the challenging operating environment but appear consistent enough to support IG ratings at the parent company. Ford’s cash balance as of last quarter was $28 billion with total balance sheet liquidity of $46 billion. Overall leverage remains low at just 2.0x adjusted debt/EBITDA at the parent company excluding Ford Credit, with pension liabilities below $10 billion as of the third quarter. Management reported an adjusted EBIT margin of 6.1% for the first half of the year, which is under pressure but commensurate with ratings and considerably stable given losses in the Model e (electronic vehicle segment).

Ford has been generating solid momentum over the past few operating cycles in key categories, such as trucks, hybrids and commercial. Perhaps most importantly, Ford also appears to be addressing its challenges head-on with a number of key strategies and initiatives across their operating platform. The more recent emphasis on quality, including key management changes, is designed to reduce long-term warranty and recall costs, which have been hampering profit margins relative to peers over recent years. Additionally, recognizing slow uptake in the Model e segment, management has been scaling back or postponing production in e-vehicles globally, and implementing job cuts where necessary.

While weakness in the Model e segment persists, Ford is adjusting capital spending relative to demand to bolster free cash flow. Total capital spending for the current year is projected to be $8 to 9.5 billion. The Ford Pro (commercial) segment continues to do very well both domestically and a bright spot in Europe and China, where they are taking restructuring charges to stem losses. Commercial is poised to further improve in Europe with the rollout of Ford’s new transit van next year. Also, the UAW strike led to a one-time $1.7 billion cost in 2023, and the new contract will weigh on margins going forward but helped eliminate a key uncertainty confronting the company.

In financing, Ford Motor Credit began the year with $133 billion in receivables in the portfolio. Tangible common equity to managed receivables stood at a very solid level of 9.0%. Delinquencies and credit losses continue to appear manageable and should eventually see gradual improvement with the lower rate environment. Ford credit has limited exposure to leases compared to other auto companies at only about 15% of receivables and is therefore less impacted by negative swings in used car prices. This could be a key consideration in differentiating financing performance from Ally, which has seen rises in delinquencies and charge-offs in late 2024.

GM also appears to be exiting 2024 on solid footing after reporting favorable operating results in the third quarter, enabling the company to raise full-year estimates for cash-flow and EPS. Comparable to Ford, GM also continues to maintain extremely low leverage at the manufacturer with adjusted debt/EBITDA as of the most recent quarter of less than 1.0x and has remained under 1x levered over the past three years. Pension liabilities were under $6 billion as of third quarter 2024 as well. Also similar to F, GM currently maintains sound liquidity with $26.6 billion in cash and marketable securities on balance sheet plus has an additional over $16 billion available to it through various revolving credit facilities. GM is currently pursuing a $2 billion fixed-cost reduction program about to be completed by year-end, most recently announcing plans to reduce 1,000 salaried employees globally earlier this month. Efforts have been made to bolster profitability and achieve higher margins commensurate with ratings.

While GM remains further ahead in the transition to EV vehicles, the company has also somewhat scaled back global expectations even as it actively seeks ramp-up of Ultium battery platform-based EVs in North America. GM is on pace to produce 200,000 EVs in North America by the end of 2024, which was scaled back and coming in at the low range of estimates (as high as 300,000) to start the year.