The net issuance forecast for 2020 is substantially lower relative to 2019 and some predictions have 2020 net issuance coming in at or near 2012 levels A few of the major investment banks are particularly bearish in their forecasts: Morgan Stanley expects net issuance to be down 22%, Bank of America down 21% and J.P. Morgan down a staggering 36%. i The decline in net issuance could be meaningful for the support of credit spreads. If continued inflows into corporate credit meet substantially lower new issuance this could create a supply-demand imbalance. This imbalance would create an environment that lends support to tighter credit spreads.
Inflows & the Incremental Buyer
IG fund flows have been broadly positive dating back to the beginning of 2016. The only period of sustained outflows from investment grade in the past four years was during the fourth quarter of 2018 which was a time of peak BBB hysteria.ii iii Over $300bln of new money flowed into IG mutual funds, ETFs and total return funds in 2019, according to data compiled by Wells Fargo Securities. The biggest story of 2019 as it relates to flows is the reemergence of the foreign investor, who has become the most important incremental buyer of IG corporates.
Foreign investors were largely quiet in 2018 but in 2019 they poured $114bln into the U.S. IG market through the end of the 3rd quarter.iv Two factors have led to resurgence in foreign demand: First, for those investors that hedge foreign currency, the three Fed rate cuts in 2019 have made hedging much more attractive, as hedging costs are closely tied to short-term rates. Second, and perhaps the larger factor, is the negative yields that foreign investors have faced in their domestic markets. Negative yielding debt reached its zenith in August of 2019 at over $17 trillion. Although it has come down substantially, it remained over $11 trillion at year-end relative to $8 trillion at the beginning of 2019.v
Obtaining precise information on foreign holdings is difficult due to the myriad of ways that this group can invest in the U.S. markets; but what was once a bit player in our market has now become the single largest class of investor, holding an estimated 30-40% of outstanding dollar denominated IG corporate bonds. To put that into perspective the next largest holder is life insurance companies at just over 20%.vi Simply put, inflows are important in order to provide technical support to the credit market, but the real bellwether for flows is the foreign buyer. If foreign money continues to flow into the $USD market, we would expect continued support for credit spreads. However, if foreign investor sentiment sours, it will create a headwind for spreads.
Best of Times & Worst of Times
Although corporate credit performed well in 2019, credit metrics for the index at large have deteriorated and leverage ratios are near all-time highs. We would typically be apt to view such a development through a bearish lens; but the reality is that much of the increase in leverage reflects conscious choices by firms rather than a weakening of business fundamentals. Incentivized by the minimal additional cost incurred for funding a BBB-rated balance sheet relative to an A-rated one, many firms have sacrificed their higher credit ratings to fund priorities such as acquisitions and share repurchases. Investor demand for credit and a prolonged period of historically low interest rates have reduced the financial penalty for moving down the credit spectrum.
Interestingly, a vast majority of BBB-rated debt has remained in the upper notches of that category. According to data compiled by S&P, just 16% of BBB- rated debt is in the lowest BBB minus category while 47% is mid-BBB and 36% is rated BBB+.vii There will surely be some losers in this bunch which makes the BBB story an idiosyncratic one; managers need to choose credits carefully in this space and focus on those which can weather a downturn without putting credit metrics in serious peril. The median GDP forecast for 2020 is 1.8%.viii If this comes to fruition then most IG-rated companies will be able to maintain stable to improving credit metrics for the year which would be another positive for credit spreads. If growth underwhelms, it would not surprise us to see spread widening in more cyclical sectors and in the lower tier of investment grade credit. This is where our individual credit selection factors in heavily.
Risky Business
At over a decade in length, we are in the midst of the longest credit cycle on record yet the current backdrop suggests that it may have more room to run. Investment grade as an asset class is still compelling as part of an overall asset allocation but even the most bullish investor cannot expect 2020 to be a repeat of 2019 as far as returns are concerned. The fact is that there is not much room for error and there are several risks that will continue to loom large on the horizon in 2020.
- Private equity companies are starting the year with a record $1.5 trillion in unspent capital. This is not a new story and remarkably this same “record” headline could have been written at the start of each of the last four years!ix Private equity is not bad, per se, but when they become involved with investment grade rated companies it is usually to the detriment of bond investors. Understanding the intricacies of each business in the portfolio and the covenants within each bond indenture can help to avoid a bad outcome.
- Policy risk remains high. The Federal Reserve has telegraphed a relatively neutral policy in 2020, which is typically the stance that is taken in an election year, but any deviation from this path could be a shock for markets. The events leading up to the November election and its results both have the ability to effect the direction of credit spreads and the risks are skewed to the downside at current valuations.
- Trade disputes have serious potential to derail domestic and global economic growth. The reality is that until uncertainty is removed, the market is subject to volatility and headline risk associated with global trade. The implications at the sector level are particularly severe in some instances and we are positioning the portfolio to mitigate this risk accordingly.
As always please do not hesitate to call or write us with questions or concerns. We will continue to provide the best customer service possible and to prudently manage your portfolios to the best of our ability. Thank you for your partnership and continued interest. We wish you a happy and prosperous new year.
