US Investment grade credit

Improving outlook in 2016

The fundamentals of the US investment grade market have deteriorated over the last two years, but there are pockets of value to be found. 

US investment credit has witnessed its weakest period since July 2014, posting 12 months of negative excess returns on the back of fundamental concerns and releveraging. Yields are now nearly at their highest levels over the last three years, offering a significant opportunity at 3.55%. The asset class also provides diversification benefits and superior carry to government bonds. In a low-yield environment and compared with yields of 1.28% in the European credit market, US high grade credit seems to be an inevitable asset class.

Issuance still soaring

The US corporate bond market has surged by 72% since 2010 to a value of some $5.4tn, issuing $1.1tn in 2014 alone. This compares with 19% growth in the European corporate bond market over the same time period and €1.7tn in outstanding bonds (see chart “Market value” page 25).

The market is as diverse as it is large: there are around 1,100 issuers, of which 30% are financial firms and 70% are non-financials. More than half are US companies, but a large number are non-US, reflecting the need by European and Asian companies to find non-bank funding and to hedge their sources of revenues geographically.

The capital of investment-grade companies issuing bonds is currently well balanced between equity and debt (52% equity/48% debt).

This, on the face of it, indicates an asset class in rude health. However its premium over “risk-free” assets been steadily widening for the last 18 months (see below the chart on yield).

Where are we in the credit cycle?

A releveraging wave has swept across the corporate world as companies take advantage of central banks’ largesse and the resulting low-yield environment. Even companies with large cash piles are tapping the markets, unwilling to pass up a golden opportunity for cheap funding.

Armed with cheap funding, US corporations have funded M&A sprees in a bid to drive up revenues and have also increased their share repurchase programs. As a result, share repurchases are at their highest level in 10 years, while M&A is now close to its 2007 level, just before the credit crisis hit.

Some of America’s biggest and best-known companies have joined this M&A spree: for instance, AT&T bought DirecTV for about $65bn in June; Facebook bought WhatsApp for about $22bn in October 2014; and GE was finally given permission in September to purchase Alstom for about $17bn .

As a result of all this activity, the debt-to-assets ratio – often referred to as balance sheet leverage – stood at some 32% in Q3 2015. This is the highest level for 10 years.

Likewise, the debt-to-EBITDA ratio – sometimes called operating leverage – stands at around 3.1, which is roughly the same level as at the peak of the financial crisis of 2008 and the technology crisis of 2000-2002. In fact, US corporate debt grew twice as fast as EBITDA generation in 2014. Similarly, in Q3 2015, EBITDA was flat for the year due to low global economic growth, a strong dollar and a sharp decline in energy sector prices and profits. Meanwhile, corporate debt increased by 15%.

What we see now is the later stage of a credit cycle with significant mergers and acquisitions, shareholder buyback activity and rising leverage, meaning that the credit cycle is turning in favour of shareholders at the expense of creditors. But does the information provided by these ratios necessarily indicate that a new credit crisis lurks around the corner?

Let’s not overstate likelihood of a credit crisis

Analysing the financial credit health of US companies requires the assessment of financial leverage, debt servicing charges, profitability and liquidity. Even if leverage appears as a red flag, other fundamental indicators should provide comfort to bond investors.

First, the leverage ratio (debt to EBITDA) should stabilise next year at around 3 thanks to expected EBITDA growth of 8% and a moderate 5% indebtedness (see chart above). Meanwhile, an improving domestic macro environment, with estimated growth of 2.4% in 2016, should be supportive of revenue generation. Moreover, financial synergies will finally feed through from all the corporate investment activity of recent years to the benefit of EBITDA generation.

Initial tightening by the Fed will gradually increase funding costs and slow down M&A, and therefore the pace of issuance volume. With a stronger dollar and a higher US-EUR interest rate differential, more non-US companies would choose other currencies, most notably the euro. Less supply will be used also to finance share buybacks as investors push companies to be less aggressive in their financial profiles. We expect supply volume to decline modestly next year from the $1.2tn in 2015 and $1.1tn in 2014.

Further comfort to investors is provided by EDITDA margins, which are elevated on historical measures at around 22%. With the unemployment rate improving, wage pressures will grow and weigh on margins. However, managements will continue to adopt a disciplined approach by monitoring costs amid modest global revenue growth.

Cash positions are at all-time highs. Even if US companies are spending a lot on M&A and share buyback programs, they still have large cash piles. Since the financial crisis and the liquidity crunch of 2008, companies are more prudent and have increased cash reserves by 25%.

Then there is EBITDA coverage, which is on average 15 times interest charges. A sharp decline in borrowing costs has allowed companies to raise debt and lengthen their maturity distribution without increasing their debt charges. The average coupon on new bond issues has declined in average from 6% in 2008 to 3.3% this year.

Finally, the default rate, which at Q3 2015 stands at historical lows of about 2.5%, is likely to rise to only about 3%-3.5% next year, compared to the 5.8% priced in by the market. Easier lending bank standard and better US economic perspectives will cap the default rate.

All of this means that the US corporate bond sector is unlikely to fall off a cliff anytime soon.

Conclusion – choose your bonds with care

Although there is reason to be optimistic on US investment grade bonds, this optimism doesn’t extend to all sectors. Commodity-related companies, for instance, will continue to come under pressure from low prices, high leverage, weaker long-term demand and a high risk of downgrade.

However, with regulation issues now largely behind it, the TMT sector could be one source of outperformance. Some industrials – with the exception of energy-related companies – also have potential. Construction companies, capital goods enterprises and acquisitive companies will interest investors too.

The key to finding good credits in an environment where the cycle is reaching its peak is bottom-up analysis. A bond-picking approach can not only find the best performers, but can limit or avoid exposure to companies that will be shaken out as the cycle matures.

Céline Deroux
Senior Fund Manager - Corporate Bonds