06 Juni 2018, 14:08 GMT
The yield on offer for the 5yr CVS tranche is 4%, but it wasn’t long ago that to achieve 4% yield, an investor would have to reach much further out in maturity or sacrifice credit quality. But CVS is a high-quality company, the 4th largest in the US by revenue, and is focused on deleveraging for the foreseeable future. This new benchmark yield of 4% for high quality, short dated fixed income should set the tone for pricing risk for investors in other markets, whether they are overseas fixed income, equity or real estate investors.
Whilst this paints the picture of an attractive market to invest in, we are still somewhat cautious due to two main factors: idiosyncratic risks and growing new corporate bond supply. The run rate of US corporate bond supply in 2018 is down 20% compared to 2016 and 2017, reflecting the issuance void of (mainly tech) companies repatriating cash from overseas. This proverbial security blanket has helped to partially insulate credit investors during a volatile start to the year for other markets. Our fear is that the blanket gets pulled away as supply picks up rapidly in coming weeks.
We are hearing from debt syndicate desks that the month of March should see $150bn of new supply, of which we have only seen $50bn so far, with two weeks left before Easter. M&A related funding is a key part of this supply pipeline, however the quality of some recent M&A is indicative of late-cycle behaviour as vertical acquisitions replace horizontal one. We are also increasingly seeing M&A deals that are seemingly out of desperation to stave off the threat of Amazon. Much of this debt-funded corporate activity is pushing the limits on what credit metrics constitute an investment grade company, so any hiccup to the very precise assumptions of future earnings growth would cause some substantial bond (and equity) weakness. A significant additional wildcard is the ongoing proposed takeover of Qualcomm by Broadcom. If financed as currently proposed, the deal would entail a debt funding need of up to $80bn of a five times levered semiconductor company, making this by far the largest and potentially most challenging ever bond deal to be placed into the market.
Under the surface we are already seeing pockets of weakness in both investment grade and high yield. Companies as varied as General Electric, Kroger and Allergan have reported disappointing earnings and are seeing their bond spreads leak wider. We are aware of the vast piles of cash accumulated in recent years by private equity fund raisings that could well be tempted to take private some weaker performing companies, typically with high degrees of financial leverage.
So all in all, the expected rapid pick up in supply will be of lower quality than average and, as we have seen of late, much longer in duration. A greater degree of risk will end up in investors’ hands at a time where global central banks are tightening monetary policy, second derivatives of growth rates are slowing and trade protectionism and retaliation measures are on an upward trajectory. As input costs such as labour, raw materials and transportation costs continue to increase, companies will face a choice: pass higher costs through to final goods prices, or take the hit on profit margins. Corporate bonds will not be immune from the volatility that we have seen in other markets this year. Investors will need a new security blanket: a disciplined stock selection approach, with an underweight bias remains our strategy for the foreseeable future.
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