Summary
- The Bloomberg (BBG) U.S. Corporate Investment Grade (IG) Bond Index (the Index)[1] option-adjusted spread (OAS) narrowed by 9 basis points (bps) during the quarter, ending March at 90bps. Corporate credit valuations are approaching twenty-year tights.
- Fixed-rate, gross investment grade bond supply was a record $658 billion in 1Q24, up from $508 billion in 1Q23.[2] EPFR Global reported that a net $73 billion flowed into IG bond funds and exchange-traded funds (ETFs) in 1Q24.[3]
- IG issuer credit fundamentals are still broadly stable. IG mean earnings before interest, taxes, depreciation, and amortization (EBITDA) margins, on a Generally Accepted Accounting Principles (GAAP) basis, were 28 percent at 4Q23, up 300bps since bottoming in 4Q20, per Bloomberg. Margins are hovering near their highest level in 10 years.[4]
- Commercial real estate (CRE) is an area of increased focus as interest rates have risen, occupancy rates remain low and valuations have declined, particularly in the Office sector. U.S. Bank CRE non-performing loan rates are rising.[5]
Investment Review and Outlook
Economic growth remains above trend, which may make the road to 2 percent inflation bumpy.
Incoming data over the quarter reaffirmed that growth remains strong, the path to 2 percent inflation will likely be bumpy, and supply side factors, including elevated immigration levels, are helping to absorb still healthy demand.
Key macroeconomic data during March included a strong employment report that showed an increase in non-farm payrolls of 275,000, higher inflation readings,6 and an upward revision in the fourth quarter of 2023 (4Q23) gross domestic product (GDP) to 3.4 percent from an earlier estimate of 3.2 percent.7
In March, the Federal Open Market Committee (FOMC) held the federal funds rate steady at 5.25 percent to 5.50 percent. The decision appeared to be interpreted as dovish by the markets, as the Summary of Economic Projections (SEP) the FOMC continued to expect three rate cuts of 0.25 percent each in 2024.
Operating trends have improved. For 1Q24, the estimated increase in operating earnings for the S&P 500 Index is 3.6 percent, per FactSet.8 Steadier profit growth has supported credit and U.S. IG Agency rating upgrades slightly exceeded rating downgrades in 1Q24 and for fiscal year 2023 (FY23).9
Corporate event risk has returned and partially drove the big bump in 1Q24 corporate debt supply. U.S. mergers and acquisitions (M&A) were forty-seven percent higher in 1Q24 year-over-year (Y/Y) and debt-funded deals are re-emerging.10 Financial leverage is up slightly but within normal ranges.
The Breckinridge Investment Committee’s (IC’s) base case is for slowing economic growth in the second half of 2024 (2H24), based on the drag from tighter monetary policy on small businesses and lower income households who are most impacted. We expect the Fed will reduce its fed funds target rate to 4.75 percent by year-end 2024, as core inflation moves back towards target, the economy slows, and unemployment rises.
With nominal bond yields still relatively high, we view IG fixed income as attractive. However, our risk posture is defensive in credit, with spreads/valuations rich.
Valuations
Spreads moved tighter in 1Q24 and valuations are tight.
Spreads tightened by 9bps to an average OAS of 90bps in 1Q24. The corporate spread compressed to 17 percent of the Index yield at 1Q24 from 20 percent at the end of 2023.
Spreads are still wide to mid-2021 tights. But spreads and the spread as a percent of Index yield have been more compressed than they were at the end of the first quarter only less than 10 percent of the time over the last 20 years.
While spread compensation is low, the IG Index yield at over 5 percent continues to drive demand and fund inflows. The IG spread and yield dynamic is reminiscent of 2005 to 2006, based on our research.
Technicals
The market saw record IG bond supply in 1Q24 and strong fund inflows
Fixed-rate, gross investment grade bond supply was a record $658 billion in 1Q24, up from $508 billion in 1Q23. Net supply for 1Q24 was $356 billion up from $254 billion in 1Q23.
Annualizing 1Q24 supply would eclipse fiscal year 2020 (FY20). But we think FY24 is unlikely to surpass 2020, which was unique given very low-cost financing and issuers’ acute demand for term debt.
EPFR Global reported that a net $73 billion flowed into IG bond funds and exchange-traded funds (ETFs) in 1Q24. The strong quarterly tally compares to a reported $114 billion of net inflows for all of 2023.
Fundamentals
IG issuer credit fundamentals are still broadly stable.
IG mean EBITDA margins, on a GAAP basis, were 28 percent at 4Q23, up 300bps since bottoming in 4Q20, per Bloomberg. Margins are hovering near their highest level in 10 years.
IG mean total debt-to-EBITDA was 3.2 times at 4Q23, up from 3.0 times at 4Q22. Since 2014, leverage has remained in a tight band, ranging from 3.0 times to 3.5 times.
IG mean cash-to-debt was 15.1 percent at 4Q23, mostly unchanged from 15.3 percent at 4Q22. Cash-to-debt has moderated from its 2020 high during the Pandemic.
CRE Bears Monitoring as NPLs Increase.
CRE emerged as an area of increased focus as interest rates have risen and remained elevated. Occupancy rates remain low and valuations have declined, particularly in the Office sector.
Non-performing loans (NPLs) in CRE have risen across U.S. banks. Banks larger than $250 billion in assets have seen NPLs rise to 4 percent vs about 2 percent for all banks.
However, large banks with over $250 billion in assets, are diversified by loan type and have a lower percentage of CRE loans (6-percent) versus all U.S. banks (13-percent).
Sustainable Spotlight
On March 6, 2024, after two years of development, including extensive public comment, the Securities and Exchange Commission (SEC) released new disclosure requirements related to climate change; specifically, financially material risks posed to corporate operations by greenhouse gas (GHG) emissions.
The new rule’s reporting standards advance efforts to achieve more consistent, coordinated regulatory reporting across jurisdictions on a range of environmental, social, and governance (ESG) risks. Breckinridge participated in the development process through its own comments submitted to the SEC (See: SEC Proposes Climate-Related Reporting Requirements).
Final rule requirements are softer than originally proposed in March 2022 but solidified a step towards addressing standardized climate-related disclosure. For more details on the new rule, see SEC Releases Financial Climate Disclosure Rule, Marking Progress Amid Opposition.
[1] The Bloomberg U.S. Corporate IG Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.
[2] Barclays US Investment Grade Corporate Update, March 31, 2024.
[3] EPFR Global, Citi Research, US Corporate Mutual Fund Flow Report, March 31, 2024.
[4] Bloomberg Intelligence. Note: IG issuer mean financial data as of December 31, 2023.
[5] FDIC Quarterly Banking Profile, Fourth Quarter, 2023.
[6] On March 12, the Bureau of Labor Statistics reported the core Consumer Price Index (CPI) was up 0.4 percent M/M in February, as the core goods category showed an increase while services inflation moderated. On March 29, the Bureau of Economic Analysis reported the Personal Consumption Expenditures (PCE) index was higher February, led by increases in spending on services. The report showed core PCE at 2.9 percent on a six-month, seasonally adjusted annual rate basis, up from 1.9 percent in December 2023.
[7] “Gross Domestic Product, Fourth Quarter and Year 2023 (Third Estimate), GDP by Industry, and Corporate Profits,” Bureau of Economic Analysis, March 28, 2024.
[8] FactSet Earnings Insight, March 28, 2024.
[9] Corporate Ratings Trends, Bloomberg, March 31, 2024.
[10] Mergers & Acquisitions, North America, Bloomberg, March 31, 2024.
BCAI-04022024-tuiahqxf (4/4/24)
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