IG Credit: Staying Observant in a Landscape of Uncertainty

Despite healthy corporate fundamentals and a dovish Fed, negative macro headlines pushed high grade spreads wider in the second quarter.

Highlights

Global Tensions Drive Spread Movements: Investment grade corporate spreads closed out the second quarter at 115 basis points (bps) over Treasuries, after starting the quarter at 119 bps over, and then reaching a mid-quarter high of 130 bps in early June. We believe recent spread movement, albeit minimal at the end of the quarter, is indicative of a cautious credit investor that is driven more by macro headlines than underlying corporate fundamentals. Slowing economic indicators—along with negative headlines surrounding China trade talks, threats of tariffs on Mexico, and growing tension with Iran—have served as catalysts for corporate spread movements in recent weeks, as investors’ attention has diverted away from an increasingly dovish U.S. Federal Reserve (Fed). The Bloomberg Barclays U.S. Corporate Index finished the quarter with a total return of 4.48%, but a much lower excess return of 1.04%, as rates rallied and investors flocked toward the safe haven of U.S. Treasuries. BBB quality credit outperformed all other investment grade quality as of quarter end, with an excess return of 1.38%. Industrials continue to outperform both the utilities and financial sectors on both total and excess return.

Investors Remain Largely on the Defensive: A continuation of dovish comments from Fed Chair Jerome Powell, prior to the second quarter’s coined “Powell Pivot,” led to positive sentiment among high grade investors globally. But the reaction was short-lived, and investors went back on the defensive amid growing uncertainty around a number of macro events. A Fed on pause, or even ready to cut rates, should translate into a supportive environment for investment grade corporate credit, as investors begin to venture more toward risk assets. But rallying Treasury rates are putting an upward technical on corporate spreads, as the yield curve continues to flatten. Questions remain as to whether an inverted yield curve signifies an upcoming recession. We believe this is only one canary in a large coal mine, and that there are many others signals to monitor. As such, our primary focus continues to be on bottom-up security selection across all sectors.

Outlook

• Looking forward to the third quarter, our view is that spreads will likely trend wider, rather than tighten, given the abundance of macro and geopolitical uncertainties.
• The latest “no-move” orchestrated by the Fed adds to the growing tension between Jerome Powell and President Donald Trump, as the President continues to call for a rate cut—which we would view, for better or worse, as an injection of fuel into an economy that has been running on all four cylinders throughout a very long economic cycle.
• M&A activity has largely slowed this year, as investment grade companies turn toward balance sheet improvements. Given this shift, we believe a majority of future corporate downgrades will be company specific and idiosyncratic in nature, as opposed to large swaths of industries falling into high yield, as some market commentators have speculated.
• We enter into the third quarter disciplined and dedicated to our fundamental approach, as we continue to navigate increasingly uncertain waters.

1-Year U.S. Investment Grade Corporate SpreadSource: Barclays. As of June 30, 2019

Index Returns vs. IG Returns by Credit Quality and SectorSource: Barclays. As of June 30, 2019