The strength of the U.S. economic recovery is central to the Federal Reserve’s plans to wrap up its program of quantitative easing and raise interest rates, but thus far the signals have been anything but clear. The world’s largest economy contracted by 2.1 percent quarter over quarter in the first three months of the year, according to the Bureau of Economic Analysis, only to rebound to a stronger-than-expected rate of 4.2 percent from April through June. Job growth remains tepid — in August the U.S. economy added a disappointing 142,000 in new nonfarm payrolls — but Americans are feeling more optimistic: The Conference Board’s index of consumer confidence rose to 92.4 in August, its highest level in nearly seven years.
That same month, while acknowledging that the U.S. economy had made “considerable progress,” Fed chair Janet Yellen reiterated the Federal Open Market Committee’s long-held view that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time” after the bond-buying program ends next month. Confused? Join the crowd.
“Fed leadership has found itself trying to explain why their interest rate outlook is apparently at odds with their economic forecast,” affirms Joyce Chang, global head of research at J.P. Morgan in New York. “The recent economic data, FOMC and Yellen’s comments all present a picture of a Fed that is moving closer to normalizing policy and raising rates.”
That may be easier said than done, notes Lee Brading, who directs credit research at Wells Fargo Securities in Charlotte, North Carolina. “The Fed’s position is not an enviable one,” he says. “Easy monetary policy and geopolitical risks around the globe should keep a lid on yields for the near term, but in the coming weeks, the Fed will be challenged as low bond yields help keep asset prices high, risk premiums tight and the new-issuance engine running.”
However, debt-financed M&A and such shareholder-friendly activities as stock buybacks increase the potential for debt growth to outpace cash flow. Brading’s crew is focused on the next FOMC meeting, scheduled for September 16 and 17, which “could set the tone in credit for the remainder of the year,” he says.
It certainly will attract the interest of investors, many of whom will be eager to hear the sell side’s interpretation of the committee’s guidance and other developments affecting the market. The firm whose analysts are the most insightful, money managers say, is J.P. Morgan, which captures first place on the All-America Fixed-Income Research Team for a fifth straight year. It claims 48 positions, four fewer than in 2013, but nearly half of this year’s total, 23, are for analysts and teams deemed the best in their respective sectors. That’s more than double the number of first-place finishes claimed by any other research provider.
In second place for a third year running is Bank of America Merrill Lynch, with 41 spots (one fewer than last year), followed by Barclays at No. 3, with 30 (down two from 2013). Wells Fargo’s modest rise from fifth place to fourth belies its sizable gains in team positions: its total vaults from 21 to 28. Rounding out the top five is Goldman, Sachs & Co., whose loss of one spot leaves it with 24. These results are based on the opinions of more than 1,970 analysts and portfolio managers at some 500 buy-side institutions that manage an estimated $9.4 trillion in U.S. fixed-income assets.
J.P. Morgan’s economics team predicts that the central bank will tighten in the third quarter of 2015, Chang reports, but notes that a rate hike in the second quarter is plausible. However, “the market is becoming more focused on how much and how fast the Fed will tighten, rather than fixating on the timing,” she adds. Her squad believes the fed funds rate, which currently ranges from 0 to 0.25 percent, will stand at 1 percent at year-end 2015, at 2.5 percent one year later and at 3.5 percent a year after that.
In the meantime issuance in many areas is expected to remain brisk as companies avail themselves of low interest rates to refinance debt, buy back shares or underwrite expansion. By late August businesses had issued nearly $1 trillion in bonds, according to Dealogic, a New York–based financial data services provider; that compares with roughly $1.5 trillion in all of last year and $1.48 trillion in 2012.
“The corporate market, particularly investment grade, has benefited from a lack of supply in other fixed-income asset classes,” says Wells Fargo’s Brading. “According to [the Securities Industry and Financial Markets Association], gross supply of dollar-denominated fixed-income assets has declined 15 percent year over year, whereas the investment-grade market is up 7 percent. As we look at high yield, we anticipate new issues in 2014 to come in just below 2013’s figure.”
Chang concurs. “An overall supply-demand imbalance persists in U.S. fixed-income markets because the supply of spread product is still running only 50 percent of precrisis levels a full seven years after [the onset of] the global financial crisis, owing to the decline in mortgage market supply,” she explains. “This has meant that the record issuance from U.S., European and emerging-market credit markets of the past few years has been easily absorbed. Pension fund and insurance company demand has also increased.”
In fact, institutional investors have lately demonstrated a willingness to go where retail investors fear to tread. The latter group pulled a record $7.1 billion from high-yield funds in the first week of August, but by midmonth institutions had stepped in to snap up bargains.
“The reasons for money leaving is largely due to concerns around low yields coupled with the perception that new-issue quality is deteriorating and will lead to higher defaults in a few years,” explains Peter Acciavatti, who pilots the J.P. Morgan squad to a 12th consecutive appearance at No. 1 in High-Yield Strategy. “We disagree with these reasons. We think new-issue quality has remained moderate, defaults will stay very low for at least two more years and high yield was trading at fair value before the sell-off — and now is slightly cheap.”
His team is urging clients to position their portfolios for rising interest and continued low default rates. “We recommend investors underweight BB-rated credits, overweight B-rated credits and second-lien loans, and market weight CCC-rated credits,” the New York–based strategist says.
Acciavatti’s colleague Carla Casella — who captures first place in two high-yield sectors, Consumer Products and Retailing, and second place in a third, Food & Beverages — says it has been a quiet year for new issues in her coverage universes, with only five through August. The largest was American Greetings Corp.’s $285 million issue to help fund refinancing related to a management buyout, but Casella dropped coverage because the Cleveland-based maker and distributor of party supplies “has always been opaque and is now likely to become more so,” she explains. “We don’t feel we have enough information to properly cover the company and make recommendations on the bonds.”
Looking ahead, the New York–based researcher urges caution. “The tepid — and choppy — consumer environment continues to worry us,” she says. “It has caused heavy price competition and margin pressure for many of the apparel businesses and even the household and health and beauty categories. We think marketing and promotions need to be sharp, and companies that manage their costs best will be able to preserve margins.”
Finding securities to recommend has not been a challenge for Citi’s Manish Somaiya, who appears in three high-yield categories: He’s No. 1 in Manufacturing/General Industrials and Services and No. 3 in Autos & Auto Parts. The New York–based analyst has been upbeat on the prospects of Atlanta’s First Data Corp., a provider of payment processing services, since initiating coverage in December 2012. He rated FDC’s 14.5 percent holding company payment-in-kind notes a buy in April; by the end of June, when he downgraded the bonds back to neutral, they had generated a total return of 19 percent, Somaiya reports. “Additionally, the buy-rated 11.75 percent subordinated notes and 10.625 percent senior notes have returned 16 percent and 11 percent, respectively,” year to date through mid-August, he says.
Another winning recommendation: Manitowoc Co. Late last year the Citi analyst urged clients to buy the Wisconsin-based construction services provider’s 5.875 percent senior notes over the 6 percent senior notes of Westport, Connecticut’s Terex Corp. In July, as Manitowoc became a target of activist investors determined to break up the company, he urged clients to take profits — a recommendation that resulted in a 14 percent total return on the notes, more than double the gain on Terex’s, Somaiya says.
Opportunities also abound among investment-grade health care names, according to Hima Inguva, who jumps from third place to first for coverage of the category. “Technicals are strong,” the BofA Merrill analyst says. “Record high supply continues to be met with robust demand for new issuance even as new-issue concessions are minimal across the curve, both for high- and lower-quality names.”
In just the first half of the year, Inguva adds, companies she covers reported $150 billion in M&A activity and $41 billion in new-issue supply. If the pace continues, the value of mergers this year could best the $250 billion record the sector saw in 2009, and issuance will exceed last year’s $57 billion total.
However, deal financing is not without controversy. Last month, Burger King Worldwide shone a spotlight on tax inversion when the Florida-based operator of fast-food restaurants announced plans to acquire coffee shop chain Tim Hortons and move its headquarters to the latter’s home country of Canada, thus availing itself of lower corporate tax rates — a practice that President Obama is urging Congress to prohibit. Such schemes have been utilized in the health care sector for years.
“Tax inversion has been driving the bulk of large deals,” contends Inguva, who is headquartered in New York. For example, Jazz Pharmaceuticals, formerly of Palo Alto, California, shifted its headquarters to Ireland after buying that country’s Azur Pharma in January 2012 in an all-stock deal valued at roughly $500 million. In October 2013, Actavis, a Parsippany, New Jersey–based maker of specialty pharmaceuticals, acquired Ireland’s Warner Chilcott in an $8.5 billion transaction; and in December of that year, Allegan, Michigan’s Perrigo Co., a maker of over-the-counter medications, completed its $8.6 billion takeover of an Irish company, Elan Corp. Endo Health Solutions, a Malvern, Pennsylvania–based pharmaceuticals manufacturer, finalized its $2.7 billion acquisition of Ireland’s Paladin Labs in February; the new Dublin-headquartered company is called Endo International.
Notable pending M&A funding issuance needs include $15.5 billion from Chicago-based drugmaker AbbVie for its $54 billion acquisition of Ireland’s Shire; roughly $5 billion from Medtronic, a Minneapolis-based medical device manufacturer, for its $43 billion acquisition of Ireland’s Covidien; and $7 billion from Switzerland’s Roche Holding for its $8.3 billion acquisition of InterMune, a biotechnology outfit located in Brisbane, California, she adds.
“Our supply forecast for 2014 is $70 billion to $80 billion, with about $50 billion priced year to date,” Inguva said in mid-August. Her advice to clients? “Focus on companies with solid fundamentals, clear delevering plans, conservative management commentary with a low probability of rating downgrades and a potential widening of credit spreads,” she says. “We suggest caution toward companies lacking strong commitment to investment-grade ratings in order to limit potential downgrades to high-yield levels.”
The leveraged-loan market is also gaining increased scrutiny from policymakers. In July, Yellen said she saw signs of an asset bubble forming and indicated that regulators would be closely monitoring the situation.
John David Preston, who guides the Wells Fargo team to a second straight appearance at No. 1 in Collateralized Loan Obligations, thinks such concerns may be overstated. “It appears that regulators are particularly looking at loans with a total leverage of more than six times, as well as structural provisions such as covenant-lite features,” the Charlotte-based team leader says. “However, multiples of the most highly leveraged loans are still below the levels of 2006 and 2007.”
CLO issuance is also at a torrid pace this year. By mid-August it had nearly reached $83 billion, the total volume for all of last year, Preston reports. “We expect issuance to continue to be robust through year-end 2014 as well as through 2015, as demand is strong,” he says. Plus, “managers have incentives to issue CLOs before risk retention regulations take effect” in the second half of 2016.
“Senior debt tranches continue to offer good relative value, especially as the large amount of issuance has limited spread tightening,” Preston observes. More broadly, however, “loan market fundamentals are on a general downward trend,” the strategist says, owing to a declining credit environment. “Leverage is increasing, but defaults are still far below historical average levels,” he adds.
This is just one of the ways in which the U.S. fixed-income market is changing, and investors must be prepared. “Five years of asset price inflation have lowered the returns we can expect in the future,” says J.P. Morgan’s Chang. “It’s essential to make active and more selective investment choices between asset classes, companies and countries.” • •
