Credit Strategy & Research. U.S. Corporate Credit Outlook A Year of Transition

Transcription

1 Credit Strategy & Research U.S. Corporate Credit Outlook 2014 A Year of Transition Trey Winslett, CFA Vice-President Credit Strategy Trey.winslett@wellsfargo.com Source: istockphoto: mstay March 27, 2014 All estimates/forecasts are as of 3/27/14 unless otherwise stated. Please see the disclosure appendix of this publication for certification and disclosure information

2 Key Macro Themes in 2014 Global Growth Accelerates Global growth is poised to accelerate to 3.7% in 2014 from 3.0% in 2013, as the U.S. expands, Europe climbs out of a recession and emerging markets stabilize. U.S. real GDP is expected to grow 2.5% in 2014, driven by improvement in consumer spending, business fixed investments and residential real estate. Monetary Policy Lower for Longer Aggressive monetary stimulus remains the norm in developed economies. The Fed has embarked on a strategy to taper bond purchases but stressed its forward guidance, while the ECB and BoJ remain firmly in easy money mode. Corporate Leverage On the Rise Balance sheets are likely to deteriorate as non-financial corporates continue to releverage. Low all-in cost of debt capital appears to be stirring animal spirits, as companies look to the debt market to fund M&A, capex and dividend payouts to equity investors. Inflation Creeping Higher Inflation in the United States is expected to creep modestly higher (1.5% 2.0%) during 2014 and 2015, as the headwinds from deleveraging dissipate and policy clarity emerges. Fiscal Policy No Strategic Direction U.S. policymakers remain trapped in an ideological battle over fiscal policy. An extended lame-duck session, with little strategic direction for fiscal policy, tax strategies or investment initiatives is a real possibility. The Great Rotation It Ain t So Great Fears of a mass exodus away from fixed income are unlikely to materialize with overnight interest rates near 0% and inflation well below the target level of 2%. 2

3 IG Credit Outlook 2014 Aggressively Neutral 280 bps 260 bps 240 bps 220 bps Investment Grade Credit Spreads (last four years) IG OAS 2011 IG OAS 2012 IG OAS 2013 IG OAS bps 180 bps 160 bps 140 bps 120 bps 100 bps Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec WFS Credit Strategy Forecasts YE 2013 As of 3/20 YE 2014 Bear Case Base Case Bull Case IG OAS (bp) IG Yield-to-Worst (%) IG Total Return (%) IG Excess Return (bps) Defaults (%, Spec Grade) 2.17% 1.78% 3.0% 2.5% 2.4% IG Gross Supply ($bn) IG Net Supply ($bn) Source: Wells Fargo Securities, LLC 3

4 Investment Grade Corporate Credit Outlook: Fundamentals Fundamentals Overall, the economy is slowly improving, while corporate creditworthiness deteriorates. U.S. economic fundamentals should continue to improve in 2014, albeit at a below-trend pace with real GDP of 2.5% expected. Inflation is likely to rise toward 2.0%. Real disposable personal income is expected to grow 2.0% 2.5% in 2014, while corporate profits after tax are forecast to grow 3%-5%. Corporate borrowing is likely to rise 5% 7%. IG credit fundamentals are likely to deteriorate further, as companies borrow more than they earn. However, the trend appears modest as it is driven by idiosyncratic factors rather than a systemic increase in debt-financed activity. 4

5 Macro Fundamentals Underpin the Credit Cycle A Typical Corporate Credit Cycle Deterioration 3 Sub-Phases: Modest, Material, Unintentional Releveraging Profits decelerate/decline Yields rise then decline Spreads grind tighter then widen Recovery Deleverage Profits rise Yields stabilize Spreads gap tighter Today s credit market Consolidation Leverage troughs Profits peak Yields rise Spreads tighten Source: Wells Fargo Securities, LLC 5

6 Credit Fundamentals Start with Leverage 45% 40% 35% IG Nonfinancial EBITDA and Debt Growth IG Nonfins Debt Growth YoY IG Nonfins EBITDA Growth YoY 30% 25% 20% 15% 10% 5% 0% -5% 2.6 x 2.5 x IG Nonfinancial Leverage and Coverage IG Nonfins: Total Debt / T12M EBITDA (lhs) IG Nonfins: Interest Coverage (rhs) 16 x 15 x 2.4 x 14 x 2.3 x 13 x 2.2 x 12 x 2.1 x 11 x 2.0 x 10 x Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Source: Wells Fargo Securities, LLC, Bloomberg (all charts) 6

7 Credit Fundamentals Drive Defaults and Ratings Migration Trailing 12m US Speculative Grade Default Rate 20% 18% 16% 14% US spec default rate Non-US spec default rate 12% 10% 8% 6% 4% 2% 0% Trailing 12m Moody s Ratings Drift* 10% 5% 0% Global US Europe -5% -10% -15% -20% -25% -30% -35% Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12 Nov-12 May-13 Nov-13 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Source: Moody s & Wells Fargo Securities, LLC* (Upgrades-Downgrades)/Rated Issuers 7

8 The Front End is Different Financials Dominate the Front End GICS Sector Front End Weighting Overall Index Weighting Difference Communications 7.7% 10.6% -2.9% Consumer Discretionary 4.8% 4.6% +0.2% Consumer Staples 8.3% 8.5% -0.2% Energy 9.3% 12.8% -3.5% Financials 42.8% 31.6% +11.2% Health Care 7.5% 8.1% -0.6% Industrials 5.4% 6.3% -0.9% Materials 3.6% 5.5% -1.9% Technology 5.4% 4.8% +0.6% Utilities 5.0% 7.4% -2.4% Issuer Concentration is Greater Rank Front End Overall Index Ticker Weight Ticker Weight 1 BAC 4.2% BAC 2.6% 2 JPM 3.3% JPM 2.4% 3 GS 2.7% GE 2.3% 4 GE 2.7% VZ 2.3% 5 C 2.2% GS 2.0% 6 MS 2.1% C 1.7% 7 WFC 1.7% MS 1.6% 8 T 1.4% T 1.3% 9 F 1.4% WFC 1.3% 10 VZ 1.3% CMCSA 1.1% Total Top % Total Top % Source: Moody s & Wells Fargo Securities, LLC* (Upgrades-Downgrades)/Rated Issuers 8

9 Investment Grade Corporate Credit Outlook: Technicals Technicals Institutional demand accelerates, while retail demand wanes. Issuance likely to remain robust. Technicals in the IG corporate credit market are underpinned by strong institutional demand. Institutional investors continue to actively seek higher yields, despite lower prices, as they attempt to match assets with long-duration liabilities. Conversely, retail investors continue to shorten duration to escape interest rate sensitivity. Corporate borrowers are likely to issue bonds at a rapid pace to lock in a low all-in cost of debt financing. IG companies are expected to issue $900 billion face value of debt next year. 9

10 Pressure Building Source: Wells Fargo Securities, LLC Mutual and Exchange Traded Fund Flows Credit Fund Flows by Duration 10 Fund Flows ($ bn) Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan Equities Credit Cumulative Fund Flows ($ bn) Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Short Intermediate Long

11 The Fed, and expectations of the Fed, are the Key Fed Funds Implied Futures Fed Funds Futures Implied Rate Fed Median 250 bps 200 bps 150 bps 100 bps 50 bps 0 bps Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 What is the Fed Saying? 5.0% 4.5% Appropriate Pace of Policy Firming Target Federal Funds Rate at Year-End December Projection March Projection 5.0% 4.5% 4.0% 4.0% 3.5% 3.5% 3.0% 3.0% 2.5% 2.5% 2.0% 2.0% 1.5% 1.5% 1.0% 1.0% 0.5% 0.5% Source: Wells Fargo Securities, LLC 0.0% 0.0% Longer Run 11

12 Investment Grade Corporate Credit Outlook: Valuations Valuations Spreads appear close to fair value. Long-end real yields look attractive. IG corporate credit spreads appear close to fair value. Our base-case year-end 2014 target for IG spreads is 120 bps versus a current value of 106 bps. Real yields on long-dated IG corporate bonds of 2%-5% look attractive as inflation remains contained while bond yields rise. The rest of the curve looks less compelling from a total return standpoint. 12

13 Yields and Spreads at the tights Front End Corporate Yields Near All-Time Lows 1-5yr YTW 1-3yr YTW 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% OAS Curve Near All-Time Steep 1-5 vs index 1-3yr Index 1-5yr Index 300 bps 60 bps 250 bps 40 bps 200 bps 20 bps 150 bps 0 bps 100 bps -20 bps 50 bps -40 bps Source: Wells Fargo Securities, LLC; YieldBook.; Bloomberg 0 bps -60 bps

14 Front End Curve is flat inside of 3 years, Steep 3-5 Shape of the Front End OAS Curve Distribution of Front End Bonds $250 Billion $200 Billion $150 Billion $100 Billion $50 Billion $0 Billion < > bps 90 bps 80 bps 70 bps 60 bps 50 bps 40 bps yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs yrs Average OAS 4 per. Mov. Avg. (Average OAS) Source: Wells Fargo Securities, LLC; YieldBook.; Bloomberg 14

15 Key Risks for 2014 Erosion of Credit Fundamentals Higher leverage, lower interest coverage, weaker covenant protection and modest downward ratings drift suggest that credit fundamentals have eroded and continue to erode. Limited investor pushback to weaker credit fundamentals may encourage companies to accelerate borrowing and releveraging. Taper Volatility The Fed surprised the market three times in 2013: 1) when it first discussed taper in May; 2) when it decided not to taper in September; and 3) when it announced in December plans to start to taper its bond purchases in January The Fed likely will be challenged to deliver a consistent message, well-timed policy action and appropriate measures throughout Fund Flows To date, the great rotation has proved to be not so great for credit investors as retail investors have largely held onto credit fixed income while selling munis and deploying cash into equities. A shift in retail behavior away from fixed income altogether is a distinct risk, but mitigated by the recent upsurge in institutional demand. Congressional Showdown Democrats and Republicans remain at odds over how to address the U.S. s fiscal position. Ideological differences and a willingness to put the economy at risk to achieve their objectives leaves holders of U.S. government debt at risk of an inadvertent mistake or miscalculation. Exogenous Shocks The possible risks from outside of the corporate bond market and outside of the United States include geopolitical risks, a sudden shift in China s economic policy, volatility in oil or food prices and/or a currency war. 15

16 Key IG Investment Themes in 2014 U.S. Investment Grade Credit: Neutral Duration Management: Long HY, Neutral IG We expect bond yields to rise (again) in As such, managing interest rate sensitivity will be paramount to capture total returns. Shorter-duration, higheryielding credit securities should outperform in a rising yield environment. Curve Position: Long 3-7 yrs, Short 7-10 yrs, Long 10+yrs Follow the money. In terms of spread performance, retail demand should continue to anchor the front end of the curve while institutional demand for long-dated IG bonds should remain healthy in early Sector Strategy: Long ENE, MAT, UTL Short HC, CS, TECH Cyclical sectors such as Energy (ENE) and Materials (MAT) should perform well as the global economy improves, while Utilities (UTL) should continue to benefit from recent credit upgrades. Conversely, event-risk prone sectors, such as Healthcare (HC), Consumer Staples (CS) and Technology (TECH) are likely to underperform. Rising Stars: Autos, Builders, Utilities While much of corporate America continues to releverage, some companies in a select number of sectors should benefit from improving credit quality and higher credit ratings. The Auto, Homebuilder and Utility sectors are likely to see a mix of rising stars in 2014 as companies migrate to IG from HY and to A from BBB. Event Risk: Strategic Shorts Corporate America continues to releverage, with a growing number of companies using debt more aggressively to fund M&A, capex and dividend payouts to equity investors. Sectors such as Consumer, Healthcare, Industrials and Tech look particularly vulnerable to balance-sheet erosion and higher leverage. 16

17 DISCLOSURE APPENDIX Additional information is available on request. Company Recommendation Definitions Buy: The security is trading cheap to its peer group and/or the market and has significant total return potential. Outperform: On a relative basis, the security is expected to outperform its peer group and/or the market. Market Perform: The security is expected to perform in line with its peer group and/or the market. Underperform: On a relative basis, the security is expected to underperform its peer group and/or the market. Sell: The security is trading rich to its peer group and/or the market and has the potential to significantly underperform based on fundamental reasons. Sector Recommendation Definitions Overweight We expect the sector to outperform the relevant broader market benchmark. Market Weight We expect the sector to perform in line with the relevant broader market benchmark. Underweight We expect the sector to underperform the relevant broader market benchmark. This report was prepared by Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients EEA The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ( WFSIL ). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 ( the Act ), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. Australia Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Hong Kong This report is issued and distributed in Hong Kong by Wells Fargo Securities Asia Limited ( WFSAL ), a Hong Kong incorporated investment firm licensed and regulated by the Securities and Futures Commission to carry on types 1, 4, 6 and 9 regulated activities (as defined in the Securities and Futures Ordinance, the SFO ). This report is not intended for, and should not be relied on by, any person other than professional investors (as defined in the SFO). Any securities and related financial instruments described herein are not intended for sale, nor will be sold, to any person other than professional investors (as defined in the SFO). 17

18 Japan This report is distributed in Japan by Wells Fargo Securities (Japan) Co., Ltd, registered with the Kanto Local Finance Bureau to conduct broking and dealing of type 1 and type 2 financial instruments and agency or intermediary service for entry into investment advisory or discretionary investment contracts. This report is intended for distribution only to professional investors (Tokutei Toushika) and is not intended for, and should not be relied upon by, ordinary customers (Ippan Toushika). The ratings stated on the document are not provided by rating agencies registered with the Financial Services Agency of Japan (JFSA) but by group companies of JFSAregistered rating agencies. These group companies may include Moody s Investors Services Inc, Standard & Poor s Rating Services and/or Fitch Ratings. Any decisions to invest in securities or transactions should be made after reviewing policies and methodologies used for assigning credit ratings and assumptions, significance and limitations of the credit ratings stated on the respective rating agencies websites. About Wells Fargo Securities, LLC Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including but not limited to Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Institutional Securities, LLC, a member of FINRA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC, Wells Fargo Bank, N.A. and Wells Fargo Securities International Limited, authorized and regulated by the Financial Conduct Authority. Important Disclosures Relating to Conflicts of Interest and Potential Conflicts of Interest Wells Fargo Securities, LLC may sell or buy the subject securities to/from customers on a principal basis or act as a liquidity provider in such securities. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC research analysts receive compensation that is based on and affected by the overall profitability of their respective department and the firm, which includes, but is not limited to, investment banking revenue. Wells Fargo Securities, LLC Fixed Income Research analysts interact with the firm s trading and sales personnel in the ordinary course of business. The firm trades or may trade as a principal in the securities or related derivatives mentioned herein. The firm s interests may conflict with the interests of investors in those instruments. For additional disclosure information please go to: Analyst s Certification The research analyst(s) principally responsible for the report certifies to the following: all views expressed in this research report accurately reflect the analysts personal views about any and all of the subject securities or issuers discussed; and no part of the research analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst(s) in this research report. 18

19 Ratings History Chart No rating information available. Distribution of Ratings As of 3/25/ % of issuers and securities covered by Wells Fargo Securities, LLC Fixed Income Research are rated Buy. 27.3% of issuers and securities covered by Wells Fargo Securities, LLC Fixed Income Research are rated Outperform. 55% of issuers and securities covered by Wells Fargo Securities, LLC Fixed Income Research are rated Market Perform. 17.4% of issuers and securities covered by Wells Fargo Securities, LLC Fixed Income Research are rated Underperform. Wells Fargo Securities, LLC has provided investment banking services for 50% of its Fixed Income Buy-rated issuers. Wells Fargo Securities, LLC has provided investment banking services for 30.3% of its Fixed Income Outperformrated issuers. Wells Fargo Securities, LLC has provided investment banking services for 21.1% of its Fixed Income Market Perform-rated issuers. Wells Fargo Securities, LLC has provided investment banking services for 27% of its Fixed Income Underperformrated issuers. This report, IDs, and passwords are available at This report is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC, to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC, at this time, and are subject to change without notice. For the purposes of the U.K. Financial Conduct Authority's rules, this report constitutes impartial investment research. Each of Wells Fargo Securities, LLC, and Wells Fargo Securities International Limited is a separate legal entity and distinct from affiliated banks. Copyright 2014 Wells Fargo Securities, LLC. SECURITIES: NOT FDIC-INSURED * NOT BANK-GUARANTEED * MAY LOSE VALUE 19