Markets surpassed expectations in 2017, supported by synchronized global growth, low volatility, and the prospect of tax reform. The Investment Grade (IG) Corporate Credit Market, as represented by the Bloomberg Barclays Index, generated a return of over 3% in excess of Treasuries. The high yield default rate improved from 6% to 3%. Moreover, after two years of rating downgrades to high yield outpacing upgrades to IG, the trend reversed in 2017. All IG sectors performed well, especially Energy, Basic Materials, and Insurance. Companies took advantage of the strong demand for IG bonds, issuing a record breaking $1.3 trillion. Revenue and cash flow growth accelerated in 2017, due to increasing commodity prices, interest rates, and worldwide growth. Companies took a pause from merger and acquisition (M&A) activity, waiting for policy clarity from the new Administration. This activity started to pick up later in the year. Median debt leverage for IG companies declined in 2017, driven mainly by commodity related firms, as leverage excluding commodity related sectors remained essentially unchanged.
Source: FactSet as of 9/30/2017, AAM (317 IG credits, excluding financials, autos, construction machinery)
For 2018, we expect continued worldwide growth to support revenues with corporate tax reform in the US enhancing cash flows for the majority of IG companies. Those with domestic focused operations are expected to benefit the most from tax reform, as they have higher effective tax rates. Importantly, while we expect most of the benefits to accrue to equity holders, there will be companies that will use the tax savings to deleverage (i.e., Pharmaceuticals). We will monitor the potential negative consequences of this reform, such as the reduction in financial flexibility for growth challenged, highly leveraged companies and/or consumers in high property and income tax states or conversely, higher than expected inflation causing the Federal Reserve to raise rates more aggressively to dampen growth.
We expect Sales growth to be around 5% with EBITDA growth approaching 10% on average in 2018. Capital spending is expected to return to the levels experienced before the commodity correction (6%+). We expect M&A activity to pick up meaningfully next year, as technology and other catalysts drive companies to vertically or horizontally consolidate. Similar to 2017, we are not expecting a material reduction in debt leverage despite positive fundamental trends due to the low cost of debt relative to equity. Given the number of companies with elevated debt leverage relative to other cycles, the credit market remains vulnerable to an unexpected shock to revenues or cash flows. This is not only an IG issue but a high yield and loan market issue as well given the percentage of credits rated B3 and lower. Due to the positive top line trend, our fundamental outlook for the corporate sector overall is stable with the most dispersion in non-financials.
The demand from investors for corporate credit remained very strong in 2017. Inflows into IG bond funds and ETFs was two to five times higher than the annual flows of the last three years respectively. In addition, demand from foreign investors remained elevated, as yields net of hedging costs remained attractive in USD denominated IG bonds. For 2018, we believe corporate credit will remain attractive to investors seeking yield (pension, insurance), but with higher hedging costs, increased supply of alternatives related to QE unwinds, and the likelihood of lower prospective total return given the expectation for higher rates, the risks are skewed to the downside. We expect credit curves to flatten, with the short end underperforming.
Developed Market fixed income supply to increase meaningfully in 2018
Our expectation is for volatility to remain historically low in 2018, with little movement in the average option adjusted spread (OAS) for the market, generating projected excess returns vs. Treasuries in IG corporate credit of between 75-125 basis points. Corporate bond spreads vs. Treasuries are ending 2017 at very low levels historically, especially for higher rated credits, reflecting the expectation for low defaults and volatility. In this environment, we are prioritizing fundamentals and credit selection. We believe identifying idiosyncratic risk at the sector and especially credit level will be very important to portfolio returns in 2018.
The sectors we believe will outperform include: Metals & Mining, Diversified Manufacturing, Wireline, Supermarkets, Pharma, Tobacco, Independent Energy, Midstream, Rail, Electric Utility, Natural Gas, Life Insurance, and P&C Insurance. Those we believe will underperform the market overall include: Health Insurance, Technology, Integrated Energy, Consumer Products, Food/Beverage, Healthcare, Auto, Cable, Media, and Chemicals.
Written by: Elizabeth Henderson, CFA
Director of Corporate Credit
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