US corporate credit cycle calls for active credit selection

David Absolon, Investment Director at Heartwood Investment Management, comments on the performance of the US investment grade corporate market

Diverging from recent trends, the US investment grade corporate market has underperformed US treasuries year-to-date. The yield spread (the difference in interest rates between the Investment grade corporate bond and the equivalent maturity risk-free rate) is at the widest level for a year and has surpassed levels during the 2013 ‘taper-tantrum’ episode.

The Barclays US Credit Index has returned 0.05% year-to-date (ended 18th September, 2015) versus a 2.37% return for the US Treasury 7- 10 year Index.

Notwithstanding well documented concerns in the energy sector, a significant driver of underperformance in the US investment grade corporate bond market has been the abundance of supply this year, largely due to increased merger and acquisition activity, especially in the pharmaceutical and healthcare industries.

Record supply was reported in July, totalling $129bn, in what is typically a seasonally quiet month. Activity moderated in August, but there are $800bn in US transactions pending this year and early in 2016 [Source: TCW].

Rising M&A indicates increasing leverage among corporate borrowers and that is always a concern for corporate bond investors. According to JP Morgan, gross and net leverage have both been trending higher since 2012 and have hit new highs since 2000.

Debt has exceeded EBITDA (earnings before interest, taxes, depreciation and amortisation) for the past three years. Interest rate coverage remains reasonably strong as debt burdens have grown, but the trend IS declining particularly as the advantage of lower coupons diminishes. Interest expense has risen to a ten-year high of $120bn, although there is some divergence within sectors.

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