Improving environment for US IG credit

US Inv. Grade credit has witnessed its weakest period since July 2014, posting 12 months of negative excess return on the back of fundamental concerns and re-leveraging. Yields are now nearly at their highest levels over the last 3 years (3.55%).

What we see now is the later stage of a credit cycle. Armed with cheap funding, US corporations have re-leveraged their balance sheet with significant M&A activity (close to pre-crisis 2007 level) and share buyback program (highest level in 10 years) (Chart 3).

Yet, the leverage should stabilise in 2016 thanks to synergies from the corporate activity (expected EBITDA growth of 8% and a moderate 5% indebtedness). Besides, companies are more prudent and have increased cash reserves by 25% to historical highs even if US companies are spending a lot on corporate investment activity. And finally, easier lending bank standard and better US economic perspectives should cap the default rate, rising only from 2.5% to about 3%-3.5% next year, compared to the 5.8% priced in by the market.

Yet, we prefer EMU IG credit

EMU companies are less advanced in the credit cycle than US companies. Moreover, we still believe that in a low yield environment with accommodative monetary policy, a gradual recovery in Europe is generally a sweet spot for corporate bonds.

On the risk side, technical indicators are less supportive. The initial tightening by the Fed will gradually increase funding costs and slow down M&A. With a higher US-EUR rate differential, more non-US companies would then choose other currencies, most notably the euro. Thus, supply & demand dynamics should be less supportive next year.

  

More positive on financials than non-financials

Strong regulatory environment and diverging trajectories of credit quality relative to non-financials make banks the most defensive sector in the IG Credit market. The recent Fed proposals about minimum debt and TLAC methodology pointed towards cooler requirements. The lower threshold and the longer phase-in are rather positive for systemic banks and there is less pressure to fulfil the debt shortfall. Within the financial sector, we have a preference for Subordinated debt (LT 2) compared to Senior debt. The carry-to-risk is more attractive for LT2 in an environment where banking issuers trade at lower levels than non-financial issuers.

Regarding non-financials, we prefer sectors less sensitive to the cycle such as Telecommunications and Consumer sectors. These sectors include many important high beta issuers from the non-core EMU universe offering an attractive yield pick-up. We keep our underweight on Oil & Gas as well as Basic Resources sectors. The recent new drop of commodities prices has again put the sectors under pressure.