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Fundamentals: A new liquidity cycle
In the past quarter, we had initially expected new debt issuance to cool and for a technical tailwind to support spread compression. That didn’t play out, with a record amount of new issuance reported in the quarter. Risks over the upcoming US Presidential election began to mount with the probability of a disputed election result and long drawn out legal dispute. With Congress unable to agree on a stimulus package before the summer, US companies brought their refinancing forward in ordre to lock-in low borrowing costs. This had the positive effect of improving the liquidity standing of corporates to a new peak, kick-starting a new liquidity cycle. Rating agency downgrades and the tally of fallen angels has decelerated from the pace we saw in the second quarter. Defaults have reached the levels seen in the energy crash of 2016, but we believe the recent shoring up of cash will stem the climb in default rates from here.
Fundamentals: Rising duration risk
With this deluge of refinancing activity, debt maturities have been extended and the low interest rate environment has helped corporates bring down the average coupon in the market. The combination of the two has resulted induration risk in investment grade markets extending by two years on average for bondholders. Investors must be mindful that this makes the fixed income market more susceptible to the negative impact of rising inflation and rising interest rates.
Valuations: A tempered rebound
Despite better than expected corporate earnings results, the rebound in risk assets lost steam through the past quarter and has been moving sideways in approach to the US election. High yield, is still down on a total return basis for the year through September and stands out as inexpensive with credit spreads trading wide to 5-year average levels. On closer inspection, the USD high yield space can be split into two with the recent wave of fallen angels helping to improve the overall credit quality of the index and in particular the BB segment. We see this in year-to-date total returns by credit rating with BB credits keeping its head above water (+2.7% return) while the single-B and CCC & below segments have fared a lot worse (-1.9% and -8.3% return respectively). We maintain our overall underweight in high yield but still have our up-in-quality preference for BB credits where we see good value for the underlying risk in select credits of that tier.
Valuations: Rotation into short and cyclical
Given the elevated duration risk but bolstered corporate cash positions, we prefer to take short dated liquidity risk and credit risk rather than going further out the credit curve. By sector, this moves us into more cyclical industries with shorter investment cycles. By credit rating, this moves us into high yield bonds which often trade to a call date earlier than its maturity date. The US automotive industry and homebuilders are two attractive short-dated areas with a supportive fundamental backdrop. We are encouraged to see US auto sales have bounced back to 16.3 million (seasonally adjusted annualized rate) through September. Moreover, incentives are meaningfully lower than during the market trough in March and average transaction prices are near historical highs thanks to tight inventory levels. Rental fleets sales are still down hard for the year due to travel restrictions but financing is widely available. In the US housing market, the supply side remains robust as seen through housing permits, housing starts and housing completions data. Rising unemployment is a clear risk to the demand side but the trend for new home orders, average sales prices and number of mortgage applications has so far been positive. We are also encouraged by the strong liquidity positions and cash flow generation of the largest national homebuilders and have comfort in highly variable cost structures and sizeable inventories, which can be liquidated in the event of declining demand.
Return of the M&A
The volume of merger and acquisition activity stalled in the first half of the year but through the combination of cheaper borrowing costs and post-Covid synergy potential, we have seen M&A deals come back again. A number of notable deals came from the healthcare space, an area that was relatively unscathed by the impact of Covid and was already ripe for consolidation following tax reform in 2017. Pharmaceutical giant Johnson & Johnson tucked in Momenta for $6.5 billion, Gilead Sciences bought anti-body drug maker Immunomedics for $20 billion and Bristol-Myers surprised us with a definitive agreement to acquire MyoKardia for $13.1 billion less than a year after paying $74 billion for the acquisition of Celgene. This tells us that there is still appetite to fund acquisitions with debt-financing in the face of rising global uncertainties, especially when the cost of borrowing is this low.
Technicals: Summer of surprise new supply
As noted above, the new bond issuance took us by surprise in the summer. US investment grade issuance in the third quarter alone totalled $382 billion and for the first nine months of the year has already surpassed prior years with a new record. Strong demand with subscriptions for new bonds ranging from 3 to 3.5 times more than supply available drove down new issue concessions (the premium in credit spread an issuer pays to attract new investment over its existing bonds). For issuers lower down in credit rating (thus with higher yields) that were able to refinance, orderbooks were even more sizeable at close to 4 times oversubscribed. There is still scope for further refinancing activity, particularly in the US high grade market where the average coupon is still 2% higher than the average yield in the market. The average coupon in US high yield is only 60bp above the average market yield and so we expect new issuance for refinancing purposes to slow down from here.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, October 2020.
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