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Fixed Income

Investment Grade: Stable Fundamentals with Hints of Wear & Tear

2019 October - 3 min read

IG fundamentals held up relatively well in Q3, despite dampened sentiment and growing macro uncertainty. Spreads were unchanged, but may move wider before year-end.

Highlights

Sentiment and Spreads Tell Different Stories
Investment grade corporate spreads closed out the third quarter at 115 basis points (bps) off Treasuries, after starting the quarter at 115 bps, and then reaching a high of 124 bps mid-quarter given broader market volatility. The Bloomberg Barclays U.S. Corporate Index finished the quarter with a total return of 3.05%, but much lower excess return of 0.04% as rates fell sharply. With positive sentiment waning on the heels of the July and September rate cuts by the U.S. Federal Reserve (Fed), spreads appear to be in transitory range—with room to move wider in the near-term amid a backdrop of increasing macro uncertainty and the potential for further volatility.

As the end of the cycle has been looming over U.S. investors for some time now, the state of the economy remains top of mind. While there are some bright spots—accommodative central banks, strong technicals—concerns surrounding economic growth and a potential recession persist. While spreads have remained inside historical averages, we do not expect to see them move much tighter through year-end. We think it is more likely spreads will widen in line with their historical averages. The yield curve was either inverted or close to inverted throughout the quarter, and we continue to monitor this as we make investments.

BBBs Focus on Balance Sheet Management
Amid dampened sentiment and increased volatility in the early days of the fourth quarter, fundamentals, while largely stable, are showing slight signs of deterioration. We entered the third quarter with overall debt issuance outpacing EBITDA growth—at 5.6% versus 3.4% year-over-year (YOY)—and leverage at some of the highest levels seen post-crisis.1 At the same time, interest coverage, at 9.7x, is now close to post-crisis lows.2

Generally speaking, as the credit cycle matures, the lowest rated portion of the investment grade market tends to fall under greater scrutiny. In the current environment, we are finding that BBB rated issuers are focusing on their balance sheet more than single-A rated issuers, and have posted a faster pace of EBITDA growth in line with that. Further, they’ve done so while issuing less debt—as measured by a growth rate of 4.3% versus 8.2%—and reducing cash paid to shareholders by 1%, whereas single-A rated issuers increased it by 23% over the same period.2 For these reasons, credit metrics have shown a slower rate of deterioration for BBB rated issuers, relative to single-A rated issuers. We believe adherence to prudent balance sheet management for BBB rated companies should help mitigate the risk of a large swath of downgrades to high yield in the near term.

Outlook

  • We do not expect spreads to stay in this range for long, and believe there’s room to move wider before year-end, given the uncertain macro backdrop and potential for further volatility.
  • Approximately 30% of the global investment grade market delivers negative yields3—and due to this dynamic, we expect global buyers to remain active in U.S. dollar credit. This should provide a cushion for technicals longer term, which bodes well for corporate spreads beyond 2019.
  • We think multi-credit or opportunistic strategies can also help investors navigate periods of interest rate volatility, in both rising and declining markets. Unlike more traditional corporate and government bonds, these types of strategies are benchmark-agnostic, and therefore provide considerable flexibility and diversification, which can potentially deliver more attractive risk-adjusted returns. One area where we’re currently seeing good value is in securitizations—specifically investment grade-rated CLOs and certain parts of the asset-backed securities universe.

1. Source: J.P. Morgan. As of June 30, 2019.
2. Source: J.P. Morgan. Period is from April 1, 2019 through June 30, 2019.
3. Source: Bloomberg. As of August 31, 2019.

IG CREDIT SPREADS BELOW 5-YEAR AVERAGESBelow-Average U.S. OASSOURCE: BLOOMBERG BARCLAYS. AS OF SEPTEMBER 30, 2019.

FINANCIAL METRICS: REVENUE & DEBT VS. EBITDA GROWTHSOURCE: J.P. MORGAN. AS OF JUNE 30, 2019.

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