Investment-grade (IG) non-financial issuers have continued to show improving credit fundamentals over the last several quarters, largely due to commodity related sectors. In fact, as today’s chart shows, earnings before interest, taxes, depreciation and amortization (EBITDA) growth for non-financials is near the highest levels since 2012. Strong gross domestic product (GDP) growth, higher oil prices, improved efficiencies and easy comparables over last year’s results have been supportive of improved metrics. For the remainder of 2018, the global growth picture should continue to be favorable for U.S. corporations. The rate of improvement year-over-year (YOY), however, will likely slow as the comparable quarters become less advantageous on a relative basis.
The average price of oil was 12% higher in the four quarters ending 1Q18 compared to the four quarters ending 1Q17, helping drive improvement in the energy sector. Going forward, however, the weak comparable periods in early 2016 for commodity related sectors on a last twelve months YOY basis will no longer be relevant.
Total debt growth has also leveled out, up only 5% YOY, its slowest pace in nearly five years. The slowdown in the rate of debt growth is largely a result of the decline in mergers and acquisitions (M&A) related issuance and a much larger base of debt. M&A related debt is comfortably up in absolute terms, but, as a percentage, appears light given the much larger total debt base. Tax reform has also certainly given some corporations pause in pursuing M&A, but it is likely to pick up again as reforms are better quantified. While leverage has stabilized, it is still near post-crisis highs. This deterioration has largely come from less risky companies in the utility and tech sectors. The food/beverage and healthcare sectors, however, have seen a decline in credit metrics largely due to debt-funded M&A.
Interest expense has increased YOY, with telecom and tech leading the rise. According to JPMorgan, the average coupon of bonds issued was 41 basis points (bps) higher than the average coupon of maturing debt of IG non-financials, while it was 13 bps lower in 2017. The shift was driven by higher Treasury yields, wider spreads, longer dated issuance and larger (although still skinny) concessions. Prior to 2018, the average new issue coupon has been lower than the coupon on maturing bonds every year since 2010 – an incredible run. Results for this year seem to imply that the run of lower funding costs for issuers has come to an end.
Key Takeaway
Credit fundamentals have continued to improve for IG non-financials, with earnings growing at the fastest pace since 2012 and outpacing debt growth. Certainly, the impact of protectionist policies globally is something to watch, although they could take some time to play out. Despite the broadly solid state of IG corporate credit, bonds are trading at the cheapest spreads relative to high yield since 2011. This meaningful relative underperformance seems overdone.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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