Benjamin Lavine, CFA, CAIA
Note: an edited version of this article was originally published on ETF.com
“Many companies remain empowered to reprioritize debt reduction in their capital-allocation policies, a consideration when assessing BBB bond risk…Over the past year, more companies have started to manage debt loads and, profitability permitting, reduce leverage. This trend will persist in 2019, in our view, as economic activity moderates”
– Noel Hebert and Anna Constantino, Bloomberg Intelligence Credit Strategy Report, Published 12/11/2018.
“The only time you should eat diet food is when you’re waiting for your steak to cook.”
– Julia Childs (referenced in “When Life Gives You Lemons…,” Irish Times, 1/28/2018 )
I recently sat down for breakfast with a fellow ETF strategist, and he asked me about our current outlook for the corporate credit environment after having written a cautious ETF.com piece, “Growing Risk in Corporate Bond ETFs”, back in July 2018. I mentioned to him that investment grade valuations look more attractive (Figure 1) following the corporate credit sell-off over the past few months but that the risk is now beginning to shift from lenders to stockholders.
Figure 1 – BBB-Rated Credit Spreads Have Blown Out Over Growing Concerns that Corporate America Is Too Leveraged
In a nutshell, Corporate America is going on a balance sheet ‘diet’ after having binged on share repurchases, dividend payouts, and mergers/acquisitions (M&A). If corporate finance officers stick to their New Years Resolution of a more disciplined capital diet (with the help of their personal trainers – the Rating Agencies), this course correction in capital allocation should favor credit holders over equity shareholders.
Investor Concerns Over Fallen Angel Risk
Investment-grade credit has been caught in the risk-off dragnet that has brought down risky assets worldwide over the second half of this year. Some of the catalysts that have contributed to souring investor sentiment within investment grade credit include:
1) the downgrade of Anheiser-Busch InBev to BBB from A,
2) the downgrade of AT&T to lower investment grade following its acquisition of Time-Warner, and of course,
3) the ongoing troubles at formerly AAA-rated General Electric that have resulted in GE being shut out of the commercial paper market.
The Bloomberg Intelligence (BI) Report highlights a major concern among fixed income credit investors of fallen angel risk, or the risk of investment grade borrowers downgraded to below-investment grade (junk-rated). Fallen angel risk is no longer idiosyncratic to a specific issuer as a wave of fallen angels (BBB-rated issuers account for half of the $5 trillion investment grade corporate index) could lead to major structural issues resulting in “reduced market liquidity and changed investor composition.”
And the situation gets worse if the world enters a recession. BI estimates that “a profit correction where EBITDA [Earnings Before Interest, Depreciation/Amortization] declines more than 15% would leave [BBBs] with leverage distribution looking more like [BBs]…today’s elevated high-grade leverage profile so late in the economic cycle will likely [lead to] ratings casualties if the correction comes.”
The good news is that corporate borrowers still have some time to strengthen their balance sheets while they remain profitable, assuming the global economy doesn’t fall into recession. According to BI Report, 90% of BBB-rated issuers are reporting positive operating cash flow with 50-75% of that cash flow spent on shareholder returns.
So, corporate borrowers still have discretion to change their capital binge-worthy activities and go on a leafy-green diet encompassing debt reduction while being more disciplined in funding current operations and future growth.
The Fed: Bad News Turning into Not-So-Bad News
In our July 2018 ETF.com article, we identified Fed overshooting as biggest risk facing corporate lenders (i.e. investment grade debt holders). Indeed, ‘Fed Overshooting’ reached ‘peak’ risk following comments made by Jerome Powell in early October that the Fed was “a long way from neutral at this point.”
Since then, pressured by market volatility and macroeconomic data pointing to slowing economic growth and inflation, the Fed has scaled back its hawkish rate hike forecasts (originally three rate hikes in 2019 based on dot plot forecasts). Fed Funds Futures now expect only one rate hike in 2019 (which would take the Fed Funds Rate to 2.25-2.50%), whereas one month ago, futures were pricing in at least two more rate hikes (Figure 2).
Figure 2 – Fed Funds Futures Imply a Slower Pace of Rate Hikes in 2019
Source: Bloomberg (as of 12/13/2018)
Now, some investors are forecasting no Fed rate hikes in 2019; however, the Fed most likely wants to maintain flexibility on setting interest rates rather than be backed into a corner by market volatility. We would not be surprised if, following the December 2018 meeting, the Fed’s forward guidance leaves it room to raise rates further in 2019, but perhaps towards the back-half of 2019, in order to give enough runway for investors (and borrowers) to scale back credit risk. In other words, keep one or two more rate hikes in the freezer should the data and macro environment warrant them.
Dividend Payout Strategies – An Underappreciated Casualty of a Balance Sheet Diet
Should this scenario play out, then a Fed ‘pause’ on further rate hikes would open a window for over-leveraged corporations to improve their balance sheets through lender-friendly capital decisions at the expense of shareholder-friendly activities. Exchange-Traded Funds (ETFs) focused on dividend strategies could be at risk should this course correction in capital allocation take place.
Figure 3 displays the top 10 dividend-focused ETFs ranked by assets under management (AUM), according to ETF.com. We also show the S&P 500 Index as proxied by SPY. We calculated the portfolio-weighted credit rating exposures based on the senior unsecured credit ratings assigned by Moody’s and S&P.
Figure 3 – Many Dividend-Focused ETFs Have Embedded Credit Risk
What the table shows is that many of these dividend-focused ETFs have heightened embedded credit risk, which is normally not an issue during a healthy credit environment and normal corporate borrowing levels. Granted, the S&P 500 has roughly a third of its portfolio in BBB and below-rated issues, but the index concentrates its exposures to market capitalization rather than dividends. Since dividend-focused ETFs are delivering ‘participation’ in dividend-paying risk, then they are more susceptible to a shift in capital allocation policies that prioritize debtholders over equity shareholders.
Go Back to Eating Steak?
Are dividend policies and share repurchases sacrosanct? If the broader macro environment recovers, then, perhaps, Corporate America can go back to eating steak. But if push comes to shove, corporations will likely follow the direction from the credit agencies and risk the ire of shareholders. Time will tell, and we may see fallen angel risk remain a predominant risk in 2019, but the Fed appears to be giving a window for over-levered companies to get their houses in order.
As of the time of this writing, 3D Asset Management held VYM, SDY, SCHD, and SPY across the firm’s managed accounts. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of December 14, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or email@example.com visiting 3D’s website atwww.3dadvisor.com.