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Positive surprise could be expected on US IG

The dollar US IG recorded good performances in 2017 with an excess return of 2.9%. This positive performances have been supported by a broad synchronised upswing in the world economy, highly accommodative monetary policies and very low volatility. In a context where spreads are closing in on cycle lows, what should we expect for 2018?

Several trends have characterised the US IG market in recent years:

  • Strong inflows. The demand from foreign investors motivated by the search for yield has increased at an unprecedented pace in recent years. US credit has been treated to some extent as a rate product. USD corporate securities held by foreign residents have increased by 45% since 2012 and currently account for 40% of the USD corporate bond market.
  • Huge increase in supply. American companies have raised record amounts on the US IG market, primarily to fund M&A and share buy-backs. This market has virtually doubled in size since 2008.
  • Huge rise in corporate leverage. The rise in leverage was broad based. The leverage is high, especially if we take into consideration that the economy is in an extended expansion phase. Previous peaks were recoded following a recession against a backdrop of depressed profits. The rate of interest coverage by earnings remains adequate, but disappointing considering historically low interest rates.

 

What positive developments could we expect in 2018?

 

  • A continuation of foreign flows into this asset class.
  • A decline in the leverage of US companies. Most of companies have recently managed to stabilize/decrease their leverage thanks to (1) a positive trend in profit growth and (2) more cautious behaviour (slowdown in M&A and share buyback activities).
  • A slowdown in net supply. After the peak of 2015, net supply declined slightly due to lower requirements for new financing. This trend is expected to continue in 2018.
  • A positive impact of the tax reform desired by Trump.(1) The lowering of taxes would primarily concern companies. (2) The repatriation of cash held abroad could reduce IG issuance. (3) The non-deductibility of interest could encourage US companies to further reduce their leverage. In this new context, it would be much less attractive for companies to issue debt to finance share buybacks.

We are late in the cycle. Valuation are tight. However, US IG could be supported by positive technical factors and better fundamentals. The risks to our scenario are a sudden tightening in financing conditions or an unexpected slowdown in profits.

2017-12-08- graphe

 

AINOUZ Valentine , CFA, Credit Strategy
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Positive surprise could be expected on US IG
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