This Investment-Grade Corporate sector report is excerpted from Guggenheim Investments’ First Quarter 2019 Fixed-Income Outlook
Investment-grade credit was drowning in complacency as third-quarter 2018 earnings announcements contained few surprises. Credit fundamentals were steady, and gloomy macro headlines surrounding geopolitics and trade wars were omnipresent, but largely ignored. After a meaningful move wider in the Bloomberg Barclays U.S. Corporate Index from the tights of 2018 of 85 basis points to late August’s 113 basis points, the fourth quarter appeared poised to follow the "Christmas rally" script of the prior two years. Instead, a spike in volatility driven by news on tech, FAANG, Huawei, and FOMC posturing exposed how poorly corporate credit can trade during a period of heightened illiquidity (see chart, top right). December illiquidity is not uncommon, but fund flows, supply technicals, and constrained dealer inventories amplified it to extraordinary levels.
The stage for December’s liquidity event was set earlier in the quarter as the outflows from investment-grade funds accelerated. Fourth quarter outflows ultimately reached $29.9 billion, erasing a third of prior year-to-date net inflows. Corporate bond trading volumes fell 8 percent from October to November and 23 percent from November to December, according to TRACE data (see chart, bottom right). The result was a rout of corporate bonds spreads of 46 basis points in the fourth quarter, or 43 percent spread widening. The weakness in the credit markets caused a dearth of new-issue supply in December, as the primary market produced a mere $9 billion of investment-grade supply. This represents the lowest December issuance for 18 years, and far below the $42 billion average. Low issuance levels are typically considered a positive technical for the market, but the lack of price verification in the primary market gave rise to an inability to price risk in the secondary market. Dealers cleaning up their balance sheets and reducing risk heading into year-end only exacerbated the move.
Confirming our Global CIO and Macroeconomic and Investment Group’s expectations, we experienced an Indian Summer in the investment-grade corporate bond market in the early weeks of 2019. Spreads rebounded, tightening from the recent peak. Looking forward, we will continue to move up in quality, as higher quality credits should better weather a cyclical downturn. Identifying strong and/or improving balance sheet stories will be key, as BBB financing costs have become elevated alongside wider corporate spreads. In addition to the up-in-quality trade, we will focus on reducing exposure to industries and credits we think will underperform in an illiquid and recessionary environment. The dramatic selloff in December reminds us to be mindful of the true cost of liquidity.
-Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Managing Director
Important Notices and Disclosures
This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC.
Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information.
Investing involves risk, including the possible loss of principal. Investments in bonds and other fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline. Investors in asset-backed securities, including mortgage-backed securities, collateralized loan obligations (CLOs), and other structured finance investments generally receive payments that are part interest and part return of principal. These payments may vary based on the rate at which the underlying borrowers pay off their loans. Some asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, causing their prices to be volatile. These instruments are particularly subject to interest rate, credit and liquidity and valuation risks. High-yield bonds may present additional risks because these securities may be less liquid, and therefore more difficult to value accurately and sell at an advantageous price or time, and present more credit risk than investment grade bonds. The price of high yield securities tends to be subject to greater volatility due to issuer-specific operating results and outlook and to real or perceived adverse economic and competitive industry conditions. Bank loans, including loan syndicates and other direct lending opportunities, involve special types of risks, including credit risk, interest rate risk, counterparty risk and prepayment risk. Loans may offer a fixed or floating interest rate. Loans are often generally below investment grade, may be unrated, and can be difficult to value accurately and may be more susceptible to liquidity risk than fixed-income instruments of similar credit quality and/or maturity. Municipal bonds may be subject to credit, interest, prepayment, liquidity, and valuation risks. In addition, municipal securities can be affected by unfavorable legislative or political developments and adverse changes in the economic and fiscal conditions of state and municipal issuers or the federal government in case it provides financial support to such issuers. A company’s preferred stock generally pays dividends only after the company makes required payments to holders of its bonds and other debt. For this reason, the value of preferred stock will usually react more strongly than bonds and other debt to actual or perceived changes in the company’s financial condition or prospects. Basis point: One basis point is equal to 0.01 percent. Likewise, 100 basis points equals 1 percent. FAANG: Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG).
Applicable to Middle East investors: Contents of this report prepared by Guggenheim Partners Investment Management, LLC, a registered entity in their respective jurisdiction, and affiliate of Guggenheim KBBO Partners Limited, the Authorised Firm regulated by the Dubai Financial Services Authority. This report is intended for qualified investor use only as defined in the DFSA Conduct of Business Module.
©2019, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.