BBB-rated credits led the first quarter recovery despite early signs of deterioration among fundamentals. With spreads significantly tighter this year, short duration credits may pose an attractive investment option.
Investment Grade Corporate Spreads Take a Turn Tighter: Investment grade corporate spreads tightened 34 basis points (bps) in the first quarter of 2019, trading at 119 bps over Treasuries according to Barclays. Corporate spreads have recovered 71% of the spread widening seen in the fourth quarter of 2018. The most pronounced tightening was seen in BBB quality corporate bonds, which tightened a total of 39 bps. Total return for investment grade corporate bonds came in at 5.14%, providing a net gain over Treasuries of 2.73%. Lower quality investment grade investors were rewarded the most this quarter, as seen in BBB corporate bonds, which provided a total return of 5.73%, compared to single-A at 4.70% and AAA/AA at 3.93%. In terms of sectors, industrials provided the highest total return of 5.50% with spreads coming in 32 bps, followed by financials and utilities, with total returns of 4.61% and 4.57%, and spreads coming in 38 bps and 29 bps, respectively. Investment grade corporate supply was slightly lower in the quarter, with a total of $335 billion coming to market, which puts YTD supply at only 85% of what the market saw in gross supply by this time last year.1
A Slightly Less Upbeat Tone for Fundamentals: Investment grade fundamentals began the quarter with a neutral tone—with stable credit metrics overall, and year-over-year (YoY) metrics ex-commodities showing slight deterioration. EBITDA for companies excluding commodity producers grew at its slowest pace since the first quarter of 2017, coming in at 1.0%. It is important to note that the overall decline in leverage statistics YoY has been largely driven by voluntary decisions by issuers, rather than being dictated directly from the market. This deterioration was seen as a result of merger and acquisition (M&A) activity, along with weaker trends in the utilities sector. Overall revenue increased quarter-over-quarter (QoQ) by 1.3%, marginally lower than nominal GDP growth, and debt increased by 1.2%, its slowest pace since 2010. While overall profit margins are around their post-crisis peak of 29%, when examining ex-commodity metrics, leverage is at its post-crisis high of 3.0x and interest coverage is at its low of 10.3x. Fundamentals of BBB quality issuers deteriorated more than single-A issuers; however, we are seeing shareholder payouts decline from BBB companies, which we believe is indicative of an effort to avoid a downgrade to high yield.2
Spreads Recover Much of Q4’s Lost Ground1
Tracking IG Corporate Fundamentals2
- We observed corporate spreads widening in the fourth quarter of 2018 due to market concerns that the Fed was going to tamp out growth, as well as concerns that there was a recession on the horizon. We believe that given the recent dovish tone coming from the March meeting, those events may not materialize until later 2019 or early 2020.
- At current spread levels, we believe the market is trading tight and we are in the later innings of this cycle. We are currently selling down risk. We are taking out longer-dated holdings and replacing them with higher yielding front-end securities sourced from our best ideas.
- We believe that the debate over the foreboding BBB space will continue to be front of mind for investment grade investors, but think it is less of a concern given that most of these issuers have multiple levers to pull to help prevent the “fallen-angel” drop to high yield.
1. Source: Barclays. As of March 31, 2019.
2. Source: J.P. Morgan. As of March 31, 2019.