The worst year for corporate debt in a decade is just the start of the slump.
That’s according to Jason Shoup, head of global credit strategy at Legal & General Investment Management America, who said that rising rates, fading stimulus, weaker earnings and potentially more downgrades all add up to a tough year ahead for U.S. investment-grade credit.
“It just feels like a much more risky proposition than it did a year ago,” said Shoup, whose Chicago-based firm manages $186 billion in assets, including $100 billion in fixed income, in a phone interview. “There really is no corner in which you can obviously hide.”
High-grade bonds may be able to claw back some of the steep losses seen in October if issuance slows, Asian investors stop selling and stock markets stabilize, Shoup said in a Nov. 9 phone interview. Still, next year looks dicey.
“I wouldn’t be surprised if the second half of 2019 really poses some significant challenges and could result in wider spreads,” Shoup said. “Without that central bank support and transitioning off the fiscal stimulus, our long-term outlook for investment grade is definitely on the more bearish side over the last two to three years.”
Shoup’s company — Legal & General Investment Management America — is an arm of the U.K.-based Legal & General Group PLC, which is also the parent of Legal & General America, a major player in the U.S. term life insurance market.
As the Federal Reserve reduces its balance sheet and higher rates weigh, the economic boost from U.S. tax cuts should fade, Shoup said. “The contribution of fiscal stimulus to growth has to slow. It’s not like we’re going to do another tax cut on the same order of magnitude that we once got,” he said. That will slow growth — possibly by at least 1 percentage point after the second quarter — which along with rising input costs fueled by trade wars, should have a negative impact on corporate profits.
That could mean billions of dollars in BBB rated bonds will be cut to junk. “The concern is that companies can get behind on that deleveraging path and if profits really do slow meaningfully over the next 12 to 18 months, you would think that more and more of those companies are going to get behind and be subject to potential downgrade risk or at least repricing risk,” Shoup said. As General Electric Co. trades more like high yield, Anheuser-Busch is also a concern, Shoup said. “If Anheuser-Busch loses its Moody’s rating — which we think is likely — do we get a repeat of GE, in terms of Anheuser-Busch? At the moment I would say Asia has been selling GE risk but has been willing to buy Anheuser-Busch risk, so it seems less likely,” Shoup said.
Shoup said he expects less liquidity in the market will cause more volatility. Secondary liquidity is worse than it was during the last big credit sell-off at the beginning of 2016. The shape of the yield curve has made dealers reluctant to hold bonds because of the negative carry, just as foreigners may be becoming more reluctant to buy, according to Shoup. “Asia and the foreign bid has been such an important component to demand in the credit markets in the last few years. Any sniff that they’re going to turn into a seller of a certain name has this potential to trade an exaggerated move wider,” he said.
Diamonds in the Rough
Shoup said he sees potential opportunities in energy pipeline and financial sector bonds. Temporary increases in leverage by Master Limited Partnerships, so that holding companies can buy out operating units, make those bonds attractive, he said. “The Williams, the Energy Transfer Partners — those are companies that trade on the riskier side in terms of spread and we think that will continue to outperform,” Shoup said, adding that his firm has a strong conviction about the trade. Legal & General also likes banks, particularly after they failed to issue new debt following earnings. Shoup said he is “cautious” on the pharmaceutical sector, and is awaiting more mergers and acquisitions. Underscoring its defensive positioning, Legal & General has a higher than average allocation to cash and Treasuries, he said.
Editor’s Note: Why This Matters to Agents Who Sell Life Insurance and Annuities
Life policies and annuities are, in effect, burrito wrappers for life insurance companies’ investments.
Life and annuity issuers use large amounts of bonds, notes and other debt securities from highly rated companies to back products that tend to stay in force for a long period of time, or that will lead to claims or payment streams that are likely to last for a long time.
The list of products backed by especially large pools of debt securities includes life insurance, annuities, long-term disability insurance and long-term care insurance.
U.S. life insurers had about 48% of their $4.4 trillion in general account assets invested in corporate debt securities in 2017, according to data from the American Council of Life Insurers’ ACLI 2018 Life Insurers Fact Book.
For life insurers, one challenge to holding of all of those corporate debt securities is that the resale value of the debt securities depends on interest rates.
If life insurers hold debt securities till the securities mature, and the issuers stay solvent and make all of their bond payments, the holders know exactly how much money they will get.
If life insurers end up selling debt securities before the securities mature, three things can happen:
- Interest rates stay the same, and the resale price of the debt securities stay about the same as the original price.
- Interest rates fall, and the resale price of the debt securities increases.
- Interest rates rise, and the resale price of the debt securities falls.
Life and annuity issuers try to cope with ups and downs in interest rates by adding interest-rate-linked adjustment features to their products.
Issuers also try to cope by matching the durations of their debt securities with durations of their insurance and annuity liabilities, to increase the odds that they’ll be able to hold on to their debt securities until the debt securities mature.
For life insurers, the possibility that large numbers of previously high-rated debt securities issuers could default is a major concern, because the returns the insurers get are based on the assumption that almost all high-grade companies will make their debt payments. If just one company fails to make payments on bonds it used to borrow $1 million, that can eat up all of the profits an insurer might get on $20 million invested in the debt securities of companies that do pay their bills.
— Read This Life Insurer Harnessed the Power of the Selfie, on ThinkAdvisor.