U.S. Investment Grade Credit Investor Update
3rd Quarter 2016
Market Review
Outlook and Strategy
In our outlook for last quarter we mentioned that we were positive on
investment grade corporate bond credit spreads* coming into the third
quarter because we believed that a strong technical backdrop would be
the primary determinant of how the market would perform. And this was,
in fact, the case. Corporate financial fundamentals were decent, but mixed.
Credit spreads were attractive to us, though absolute yield levels were well
below the five-year average. Nonetheless, market technicals remained
incredibly strong. This was due in large part to strong overseas demand for
U.S. corporate bonds given their relatively attractive yield compared to
foreign bond markets where yields are close to zero, if not negative.
Consequently, investment grade corporate bond spreads continued their
tightening trend during 3Q2016, reaching year-to-date tights during
August before backing off slightly in September. The Bloomberg Barclays
US Corporate Index tightened 18 basis points (bps) to end the quarter at an
Option-Adjusted Spread (OAS) of 138.1
As we enter the fourth quarter, we continue to be positive about the high
grade credit market. Corporate debt levels continue to increase, causing
deterioration in interest coverage ratios, but the expected pickup in U.S.
growth during the back-half of the year should help revenue, and profit
margins continue to be strong.2 Valuations are attractive, in our opinion, as
credit spreads have widened since 2014, and now sit slightly below their 15year average. Credit spread curves continue to look attractive to us, as well,
as they remain steep on a long-term historical basis. Once again, however,
we believe that supply/demand will be the primary driver of performance.
We anticipate that supply will remain robust, but less than we saw in the
third quarter. Demand, on the other hand, should continue to be strong as
the global reach for yield continues. With the market assigning an
approximately 60% chance of a rate increase by the FOMC at its December
meeting, higher U.S. Treasury yields could prove an additional factor
contributing to increased demand. That said, should a Treasury market
selloff become disorderly (such as occurred during the 2013 “taper
tantrum”), credit spreads could widen as buyers wait for interest rates to
find support.
It was notable that despite volatility in commodity prices, investors
appeared to give increased credence to the view that supply/demand
imbalances should improve into 2017 and beyond. As a result, the energyrelated and metals/mining sectors were strong performers. More broadly,
despite a healthy new issue calendar, robust demand allowed the market to
easily absorb new issues – many of which priced tight to existing secondary
bonds as strong order books eliminated the need for the more customary
new issue concessions. Another indication of the “risk-on” character of the
quarter was that crossover credits (which still have a non-investment grade
rating from one of the three major rating agencies) were the best
performers across the investment grade credit quality spectrum in all three
months.
During the quarter, changes in the shape of credit curves were arguably of
greater impact than changes in yields. This was primarily the result of two
factors. First, with the implementation of money market reform rapidly
approaching, short-term interest rates increased, flattening the front-end
yield curve, as the anticipated return from “rolling-down-the-curve”
decreased. Second, market disappointment with both the Bank of Japan
and the European Central Bank for failing to aggressively commit to
extending and expanding their Quantitative Easing (QE) programs led to
dramatic selloffs at the long-end of their yield curves. This weakness quickly
spilled over to the U.S. Treasury market, and pushed U.S. 30-year Treasury
yields higher. We believe that such concerns over global central banks
having exhausted QE’s ability to support asset prices will continue as a
significant source of market volatility.
In the U.S., the September Federal Open Market Committee (FOMC)
meeting was unsurprising in that they did not hike interest rates. What was
surprising, however, were the three dissents from members who felt that
rates needed to be raised immediately, lest the Federal Reserve risk pushing
the economy into recession if they have to tighten more aggressively in the
future should inflation rapidly pick up. Highlighting the stark division
within the FOMC, however, the Summary of Economic Projections (SEP), or
“dot plot” showed that three other members envision no action by the
FOMC for the balance of 2016. Clearly, Janet Yellen will have her hands full
if she hopes to forge a consensus.
Hence, aside from the obvious volatility that could result from the U.S.
Presidential election, we see global central bank policy shifts as possibly the
most significant risk to our view. With the Bank of Japan (BoJ) and the
European Central Bank (ECB) both in the middle of evaluating future
options for their extraordinary monetary and QE policies, there is a
heightened chance that the market will experience additional bouts of
“risk-off” should the BoJ and ECB be seen as once again failing to deliver
additional support. The market would appear to need more asset
purchases, and for a longer period of time, to prevent foreign bond yields
from rising back toward what in our opinion would be more rational levels.
On the domestic front, it appears to us that, broadly speaking, the dovish
majority within the FOMC is willing to hold off on raising rates because they
believe that accommodative policy is helping draw workers back into the
labor force, and that this should be allowed to continue until either labor
market slack has been absorbed, or until inflation actually hits the Fed’s 2
percent target. They seem unconvinced by arguments that holding interest
rates at historically low rates so long after the recession ended risks creating
distortions that threaten financial instability. Moreover, concerns about
global growth (e.g., China) and international market volatility spilling over to
the U.S. only seem to reinforce their desire to stand pat. As such, we cannot
avoid a nagging suspicion that the doves on the FOMC may try to find an
excuse to hold off at the December meeting, and that even if they do hike at
their next meeting, it will likely be another 6-12 months before they
seriously consider another move–absent a dramatic acceleration in inflation.
We also believe that the U.S. dollar is going to play an important role in the
Fed’s decision-making process, as hawkish moves by the Fed, against the
backdrop of monetary stimulus abroad, could result in a spike in the USD–
which would pressure the Chinese yuan-peg,* pressure U.S. corporate
earnings from overseas, and undermine the recent recovery in commodity
prices.
In sum, while we see macroeconomic risks to our positive outlook for the
investment grade corporate bond credit market, we continue to believe
that strong demand for U.S. corporate bonds will continue to support credit
spreads. We also believe that, for the near-term, any increase in interest
rates will be tempered by weak global growth, dovish central banks, and a
lack of an actual (as opposed to anticipated) pickup in inflation.
First Trust Advisors L.P. • 1-800-621-1675 • www.ftportfolios.com
Bloomberg Barclays U.S. Corporate Index Segments
3Q 2016 Total Return* (6/30/16 to 9/30/16)
U.S. Treasury Curve
2.5%
2.0%
1.5%
1.0%
0.5%
Source: Bloomberg
0.0%
1M
3M
6M
1Y
2Y
6/30/2016
3Y
5Y
7Y
10Y
30Y
9/30/2016
240
220
200
180
160
140
120
3.7%
3.5%
3.3%
3.1%
2.9%
2.7%
9/
3
0/
20
10
15
/3
1/
20
11
15
/3
0/
20
12
15
/3
1/
20
1
1/
31 5
/2
01
2/
29 6
/2
01
3/
31 6
/2
01
4/
30 6
/2
01
5/
31 6
/2
01
6/
30 6
/2
01
7/
31 6
/2
01
8/
31 6
/2
01
9/
6
30
/2
01
6
Source: BarclaysLive
1.5%
2.0%
2.5%
3.0%
0.0%
Source: BarclaysLive
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Rolling 3-month Issuance of
Investment Grade Corporate Bonds (billions)
$450
$400
$350
$300
$250
$200
$150
$100
$50
$0
Source: SIFMA
$200
$180
$160
$140
$120
$100
$80
$60
$40
$20
$0
De
c
Ja -14
n
Fe -15
b
M -15
ar
Ap -15
M r-1
ay 5
Ju -15
n
Ju -15
Au l-15
g
Se -15
pO c 15
No t-15
v
De -15
c
Ja -15
nFe 16
b
M -16
ar
Ap -16
M r-1
ay 6
Ju -16
n
Ju -16
Au l-16
g
Se -16
p16
3.9%
1.0%
10+ Yr
25+ Yr
BBB
Industrials
5-10 Yr
Corp Index
Financials
Utilities
A
AA
1-5 Yr
9/
3
0/
20
10
15
/3
1/
20
11
15
/3
0/
20
12
15
/3
1/
20
1
1/
31 5
/2
01
2/
29 6
/2
01
3/
31 6
/2
01
4/
30 6
/2
01
5/
31 6
/2
01
6/
30 6
/2
01
7/
31 6
/2
01
8/
31 6
/2
01
9/
6
30
/2
01
6
Source: BarclaysLive
0.5%
Bloomberg Barclays U.S. Corporate Index Segments
3Q 2016 Excess Return* (6/30/16 to 9/30/16)
Bloomberg Barclays U.S. Corporate Index:
Yield to Worst*
2.5%
Source: BarclaysLive
0.0%
Bloomberg Barclays U.S. Corporate Index:
Option-Adjusted Spread1
100
10+ Yr
25+ Yr
BBB
Industrials
Corp Index
5-10 Yr
Financials
A
Utilities
1-5 Yr
AA
Monthly Issuance (rhs)
Rolling 3-month Issuance (lhs)
1Option-adjusted spread is the spread relative to a risk-free interest rate, usually measured in basis points (bp), that equates the theoretical present value of a series of uncertain cash flows of an instrument to its current market price. OAS can be
viewed as the compensation an investor receives for assuming a variety of risks (e.g. liquidity premium, default risk, model risk), net of the cost of any embedded options. A larger OAS implies a greater return for greater risks.
2Interest coverage ratio is a company's pretax operating income or cash flow divided by its interest obligations for a given period.
*Definitions
Bloomberg Barclays U.S. Corporate Investment-Grade Index - Measures the performance of investment grade U.S. corporate bonds. The index includes all publicly issued, dollar-denominated corporate bonds with a minimum of $250
million par outstanding that are investment grade-rated (Baa3/BBB- or higher). The index excludes bonds having less than one year to final maturity as well as floating rate bonds, non-registered private placements, structured notes,
hybrids, and convertible securities.
Credit Spread - The yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one
with less credit risk. The credit spread of a particular security is often quoted in relation to the yield on a credit risk-free benchmark security or reference rate, typically either U.S. Treasury bonds or LIBOR.
Yield to Worst - The lowest possible yield on a bond that may be called in the future. This metric is used to give an investor a worst-case scenario (short of a default by the issuer) when purchasing a bond. By using the yield to worst metric,
bond investors get a more realistic view of a callable bond’s yield.
Excess Return - Return rate on an investment relative to the return rate on risk free investment, for example the excess return for a corporate bond relative to a like-maturity U.S. Treasury. The excess return of an investment may exceed its total return.
Total Return - The overall return on a bond that includes both the excess return as well as the return from the like-maturity risk-free bond (such as a U.S. Treasury).
Yuan-Peg - China’s currency is not freely tradeable, but is instead managed by the government through being fixed, or “pegged”, to the U.S. dollar.
All charts shown herein are for illustrative purposes only and not indicative of any investment. The performance illustrations exclude the effects of taxes and brokerage commissions or
other expenses incurred when investing. Past performance is not indicative of future results and there can be no assurance past trends will continue in the future.
First Trust Advisors L.P. • 1-800-621-1675 • www.ftportfolios.com • 11/16