To Hell And Back The Year in US Credit So Far & What’s Next

April 2016

Louise Purtle

Chief Strategist

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• Reaction to December Fed tightening and outlook for four 2016 rate hikes

• Oil prices continually plumbing new lows – correlation with spreads very high

• Unabated fears of China hard landing worsening global growth outlook

• Japan’s move on yields spreading the “cancer” of negative interest rates

• Weakness in US manufacturing looked to be spreading to services

• Oil and commodity weakness driving the US default rate higher

• Banks hit on fears of energy exposures

• Impaired liquidity across markets in face of redemptions increases cross market contagion

• Extreme risk aversion disrupted operation of primary issuance markets

• Credit spreads pushed to levels not seen outside of prior crisis periods

1Q16 Was An Extraordinary Period….

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What Went Wrong Back in January?

It’s a Long List…

• The world did not come to an end; “crisis fatigue” can only last so long

• The Fed realized tightening in this cycle will be harder than it thought and backed off

• The ECB added to the “central bank” bid with further monetary support

• Oil found a bottom; markets began to focus on a return to supply/demand balance in 2017

• China numbers stabilized; government was more effective in calming markets

• US manufacturing sector data began to show “green shoots”

• Confidence restored in strength of US bank balance sheets

• Bargain hunters finally saw bargains

• Marquee names entered primary markets – deals were well oversubscribed

• Mutual funds and ETF inflows turned strongly positive

1Q16 Was An Extraordinary Period….

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Why Did Markets Rally So Strongly from Late February On?

It’s Also a Long List…

Now It’s 2Q16: What Can We Expect?

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• Market is no longer in panic mode

• Story less about supply discipline than supply/demand balance

• Range bound trade will reduce impact on equities and credit spreads

Oil prices will remain crucial – but not critical

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• 14 issuers ($38 bn in debt) dropped from IG indices in 1Q16

• We see another 14 issuers with $65 bn in debt as possible fallen angels

• Moody’s most draconian, but have acted. S&P and Fitch more sanguine

• High risk for crossover: Ecopetrol, Encana, Diamond Offshore, Repsol Oil & Gas Canada

Downgrades in the oil patch will remain a factor for IG investors

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• Country remains a major driver of risk sentiment

• Managing the transition from a manufacturing to a services economy is a huge challenge

• Excess capacity continues to send a deflationary pulse through global manufacturing

• Slower Chinese growth still has a negative impact on resource-dependent EM economies

• From an IG portfolio perspective most of the metals & mining fallen angel candidates have fallen

China is still a wild card…

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• A weak global backdrop and low offshore yields are a big constraint on US rate “normalization”

• US inflation is not showing great traction despite tighter labor markets; but watch wages

• Negative yields in many parts of the world mean money continues to target the US

• Expect conflicting Fed “commentary” on the timing of rate moves to preserve flexibility

• One (maybe two) rate hikes in 2H16 – data (and market) dependent

On rates, the Fed will “jawbone” not “t-bone”

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• A weak US 1Q GDP print quite likely given inventory trends and production readings

• Manufacturing seems to have turned the corner; latest survey readings show momentum

• Employment growth sufficient; slack in labor markets reduced, some gain in wages…but

• Consumer sector still sluggish (falling confidence, weak retail sales)

• Housing moving in the right direction; positive but minimal contribution to overall GDP

No US recession, but “stall speed” growth

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• Leverage has ticked up in all investment grade ratings categories for the past five years

• Companies are levering balance sheets to fund M&A activity and shareholder rewards

• Organic growth remains extremely challenging and few sectors have much pricing power

• Deteriorating fundamental data highlights the challenge for bondholders as rates normalize

Credit fundamentals are deteriorating

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• The US HY issuer-weighted default rate is approaching the historical average of 5.4%

• Our 2016 full-year US default forecast is 5.5%

• Of the 18 US HY defaults, ten were from commodity-based sectors

• The 1Q commodity rally suggests the pace of defaults seen in 2H15 won’t be exceeded in 2H16

Defaults are rising but remain concentrated in commodity-exposed names

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• After a virtual shutdown in mid-February, issuance has resumed with gusto

• Demand in high yield was slower to return but activity in recent weeks has been robust

• New issue concessions have become increasingly skimpy

• Deal sizes remain outsized; the mega-deals are driven by M&A and shareholder enhancement

Issuance – big deals are a big deal

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Current Portfolio Approach

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• Fed on hold till 2H16; then one, maybe two modest increases

• US IG credit should continue to outperform, but more modestly

• Maintain selective, name-specific exposure to HY credit

• Don’t mix industry risk and idiosyncratic credit risk

> Defensive names in high beta sectors

> Cuspier names in defensive sectors

• Expect a continued slow deterioration in fundamental credit quality

> A continued high level of event risk

> Flattish earnings and some sector-specific margin erosion

> Ongoing modest leveraging

• Use primary market for positioning (capture new issue concessions)

• Be sensitive to potential downgrade pricing effects

• Seek value in long corporate paper

IG Sector Comparison – Spread vs. Rating

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IG Sector Comparison – Spread vs. Duration

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Copyright CreditSights 2016.

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