It ended up being a very strong year for investment grade (NYSEARCA:IG) credit in 2017 from a performance standpoint driven by improved top line earnings fundamentals, especially in commodity-related companies, strong technical demand from non-U.S. buyers, as well as retail buyers and hopes for a better business environment coming out of Washington. Excess return for IG for the year was in excess of 300 basis points, driven by spread compression and lower rated credit and longer duration credit.
Looking into 2018 at the IG credit markets, the best word to describe our outlook is lukewarm. From a fundamental perspective, we see strong top line earnings, however also stretched balance sheets. Top line earnings continue to improve and there are potential headwinds from tax reform and decreased regulation. However, year over year comparisons may be a bit challenged. From a credit standpoint, we expect balance sheet leverage to remain at near multi-decade highs, and debt is expected to grow as fast as EBITDA as most of the benefits from improved earnings and tax reform flow to the shareholders in the form of M&A, share buybacks and dividends. We also expect late cycle credit behavior in many industries but not all, where shareholders are the main focus. From a technical perspective, we see things as mixed and believe they could worsen in the second half of 2018. We expect new issuance to modestly increase versus 2017 as a result of increased M&A activity, despite a slow-down in issuance in some industries as a result of tax reform and specifically repatriation. As the pace of tapering picks up in the second half of 2018, we expect the total supply of investment grade assets available - U.S. Treasuries, mortgage backed securities and investment grade corporates - to substantially increase. On the demand side, we expect continued foreign demand, as long as the U.S. markets remain substantially higher in yield than most other developed markets like continental Europe and Japan. In 2017, we saw strong retail flows, however we don’t expect 2018 retail flows to remain quite as strong. Also, pension and insurance company demand for long maturity bonds should be strong as rates rise. Still, short maturity demand may suffer as cash rich companies liquidate some of their portfolio as a result of repatriation. In sum, technicals should remain decent early in the year, but could crack in the second half of 2018 as a result of Fed tapering and asset rebalancing combined with robust new issuance.
From a valuation perspective, we are at a post crisis spread tight for the market and for the investment credit market in general. However, we are still modestly cheap versus the early 1997 and 2007 cyclical peaks, but less so when adjusting for the lower credit quality and longer duration of the market today.
Also, we are still cheap on a yield basis versus local currency denominated investment alternates in continental Europe and Japan, but less so when adjusting for a currency hedge. Luckily there are still several industries that remain cheap to their post financial crisis spread tights. In sum, the lukewarm investment grade credit corporate market outlook is based upon relatively strong earnings fundamentals, offset by stretched balance sheets, positive yet questionable forward-looking supply/demand technicals and full valuations from a historical standpoint, yet still attractive versus global alternatives. As a result, we believe it’s best to stay close to home in our investment grade credit allocation, and concentrate on generating alpha through industry and name selection, while remaining nimble and proactively managing overall credit risk.
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