SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Fuel for innovation outsourcing
Tim Lee , CFA, Senior Credit Risk & Research Officer
The escalating pace of innovation is an existential threat to incumbent companies across all industries. New technologies, data intelligence, social media and agile startups are shifting the traditional marketplace for everything from cars, hotels, grocers and consumer goods to healthcare, entertainment and technology. In an effort to avoid the same fate as video rental stores and one-hour photo labs, established market leaders without the dexterity to respond quickly to threats are increasingly outsourcing their own innovation efforts by acquiring new technologies and products through mergers and acquisitions (M&A).
If innovation outsourcing has become a key to corporate longevity, the question becomes one of tactics. In many instances, corporations turn to the fixed income markets, adding leverage to help finance these M&A activities. In 2017, approximately $188 billion in U.S. investment-grade debt that listed “acquisition financing” as one of the uses of proceeds was issued. This year, $104 billion of corporate bonds issued on the same basis has already been underwritten.
*U.S. dollar bond issuance by corporations (excluding government and government agencies) rated at least BBB- or Baa3 by S&P or Moody’s, respectively, with acquisition financing listed as one of the uses of proceeds.
**2018 full-year estimate based on the pace of average issuance volume through May 2018.
Source: Bloomberg, SVB Asset Management.
Consider these three noteworthy debt issuances from earlier this year as examples of innovation-driven borrowing:
- CVS Health Corporation: $40 billion was issued in March to pay for an acquisition of health insurer Aetna Inc. The largest U.S. retail pharmacy and second-largest pharmacy benefits manager was compelled to defend against disruption in the pharmacy supply chain. Along with the CVS MinuteClinics that aim to compete with startup primary care practices, the CVS-Aetna combination is a response to the budding field of healthcare delivery innovators.
- Salesforce.com Inc.: $2.5 billion in debt was sold in April to finance the purchase of connectivity software maker MuleSoft Inc. Facing mounting challenges, one of the world’s leading software providers acquired the technology needed to help its products interface with a client’s existing suite of products. Salesforce effectively outsourced its software integration efforts by buying MuleSoft.
- Celgene Corporation: $4 billion in bonds was issued in February for the purchase of immunotherapy company Juno Therapeutics Inc. The third-largest U.S. biotech company was falling behind its competitors in bringing
CAR-T cell therapies to market. The Juno acquisition gave Celgene full ownership of cutting-edge cancer treatment technology. In a similar move, Celgene competitor Gilead Sciences Inc. borrowed $3 billion from investment-grade bond investors in September 2017 to buy Kite Pharma Inc. and its CAR-T therapy pipeline. Like Celgene, Gilead outsourced CAR-T innovation by buying it externally rather than developing it internally.
So, what are fixed income investors to make of all this? In general, acquisitions often have a mildly negative effect on the credit profiles of investment-grade companies. During the period from January 1986 through March 2018, Moody’s found that where M&A contributed to a rating change, 59 percent of those changes were downgrades. On the same basis for the year ending in March 2018, there were 17 downgrades and 15 upgrades linked to M&A activity. Through the first quarter of 2018, Moody’s reports that M&A activity resulted in the same number of upgrades and downgrades. For the three large transactions cited above, there was no rating action taken by Moody’s or S&P on Celgene and Salesforce. CVS was downgraded one notch by S&P and is slated for “Review for Downgrade” by Moody’s, but the company is expected to remain investment grade.
The result of all this innovation outsourcing should provide bond investors with a steady supply of new issuance; however, it also presents some risks. At first blush, these risks appear manageable because many investment-grade companies enjoy strong, free cash flow and the capacity to innovate by purchasing it externally. Therefore, any M&A transaction that solidifies a company’s competitive position, enhances its product offering, increases its efficiency or allows it to enter a new market has the potential to bolster future cash flow and partially offset the near-term negatives of weaker finances.
Even with the rising rate environment, we expect investment-grade companies to keep borrowing in the corporate bond market to finance responses to innovation threats. In fact, deal making and debt issuance could increase further if the regulatory environment becomes more favorable. An upcoming barometer will be whether AT&T will prevail over government objections to its planned acquisition of Time Warner Inc. Facing the proliferation of content creation by upstarts Netflix, Amazon, Apple and Google, which has already victimized traditional cable companies and television networks, AT&T is seeking to become a formidable challenger by transforming itself into a wireless distributor and owner of content. If AT&T is allowed to consummate the Time Warner deal, investment-grade debt investors should be on alert for additional innovation outsourcing via large-scale, transformative M&A deals that will likely need sponsorship. Stay tuned.
|Total Returns: |
|ML 3-Month Treasury
|ML 6-Month Treasury
|ML 12-Month Treasury
Source: Bloomberg, Silicon Valley Bank as of 5/31/18
Credit Vista: Steady as she goes
Melina Hadiwono, CFA, Head of Credit Research
The financial performance of banks during the first quarter of this year has largely followed the theme from 2017. Profits continue to improve, thanks to rising interest rates, despite normalizing asset quality from historic lows. According to the FDIC’s Quarterly Banking Profile, the aggregate net profit was $56 billion for 5,606 insured institutions, which is an increase of 27.5 percent compared to a year ago. This was driven by loan growth, improving net interest margin and higher trading revenue. A lower effective tax rate also boosted quarterly net profit by 13 percent. The increase in revenue was broad based across institutions of all sizes, as more than 80 percent of all banks reported higher revenue a year earlier. Clearly, the earnings environment for financials is favorable.
Overall, asset quality remained stable with the net charge-off ratio at a historically low level, despite slightly higher credit card net charge offs. The industry reserve coverage ratio also increased to 110 percent, the highest level since the second quarter of 2007. Total loan balances increased by 4.9 percent, with growth from all major categories except credit card balances, which can be attributed to a seasonal decline. Tier 1 capital ratio continued to hover at a record high of 13.14 percent, though it would be unsurprising if it trended slightly downward as shareholder payout and loan growth pick up. The number of problem institutions in the quarter declined to 92 from 95, the lowest number since first quarter 2008. All these metrics confirm the relative health of the financial sector.
Going forward, ongoing monetary policy normalization and a growth economic environment should continue to support sound bank performance. The recent passage of the Dodd-Frank relief bill marks a key legislative step toward easing regulation for small and mid-sized banks, providing a further tailwind. While overall softening of regulations may have merit to reduce operating complexity, the response to any implemented regulatory changes as it pertains to capital, liquidity and risk management would be a key determinant of banks’ credit profile in the medium to longer term.
Economic Vista: Reading between the lines
Eric Souza, Senior Portfolio Manager
When the Federal Reserve speaks, investors like to dissect every word. In the May 2 Federal Open Market Committee (FOMC) statement, the word of the day was “symmetric.” The committee stated it expects inflation to run near its symmetric two percent objective over the medium term. But what does that really mean?
What the Fed is trying to re-emphasize is that the two percent inflation target is not a cap, but rather a range. Thus, with this nuanced wording, the Fed is saying it remains comfortable even if inflation exceeds that two percent threshold. More importantly, if inflation continues its upward trajectory, it does not necessarily mean a more aggressive hiking cycle. This messaging could help set expectations for the market and avoid another round of severe volatility.
So far in 2018, we have seen an increase in all inflationary readings with three of the four primary inflation gauges coming in at or above two percent, with one important exception. The Fed’s preferred inflation gauge, core personal consumption expenditures (PCE), has been at 1.8 percent for the past few months, which is the highest reading since February 2017.
Inflation is forecasted to continue rising due to the effects of the corporate tax cut, rising oil prices, additional trade tariffs and low unemployment, which could put upward pressure on hourly wages.
Inflation readings point higher – core consumer price index (CPI) and PCE
||% Change |
Source: Bloomberg, SVB Asset Management
In other economic data, the monthly employment report showed the unemployment rate fell to 3.9 percent, the lowest reading in nearly 18 years. For the moment, however, this low headline unemployment rate has not translated to higher wages. In fact, wage growth was disappointing in the April report, coming in below expectations at 0.1 percent and up just 2.6 percent on a year-over-year basis. For context, before the 2008 financial crisis, the pre-recession growth rate in wages from 2004 to 2007 was 3.2 percent. But if wage growth were to eventually kick in, it could provide another boost to inflation.
The April retail sales report was encouraging in terms of consumption spending for the first half of the year. During the second quarter, April sales were in line with expectations rising 0.3 percent, thanks to healthy gains from clothing stores, which reported the largest monthly increase since March of last year. Nine of the 13 retail categories recorded higher sales. Although consumer spending was sluggish over the winter months, the March readings were revised upward.
In terms of overall economic growth, the second estimate of first quarter GDP was revised down to 2.2 percent from the advanced estimate of 2.3 percent. This was below expectations and largely due to downward revisions to inventories and lower consumer and government consumption. Given this growth rate and the recent inflation readings, the trajectory of the Fed’s monetary tightening is likely to remain unchanged for the time being.
Trading Vista: Primary focus
Jason Graveley, Fixed Income Trader
Despite the geopolitical issues dominating the headlines and the machinations of daily market volatility, very little has changed as a whole in the credit markets this past month. The Barclays Credit Index, an index that tracks the performance of investment-grade corporate debt, has shifted 10 percent in the front end. For context, in April, this same index shifted more than 30 percent in the same duration ranges. The yield on the 2-year Treasury note, a common pricing benchmark for front-end bonds, has moved less than seven basis points month-to-date despite the release of minutes from the May FOMC meeting, the expected decision in June to raise the target range for the federal funds rate and increased Italian political turmoil.
As front-end spreads remain range-bound and secondary corporate bond supply is limited, we have seen investors shift their focus to the primary market. Recent political turmoil in Italy has put a damper on corporate issuance to close out the month of May, with only $4 billion of an expected $20 billion pricing in the final week. May was on pace to have the largest investment grade new issuance calendar this year through the first three weeks. Year-to-date, investment-grade new issuance has totaled roughly $547 billion. By comparison, investment-grade issuance through the same period in 2017 totaled $651 billion, representing a year-over-year decline of more than 16 percent. The decrease in new issuance has generally been attributed to increased daily volatility, but more specifically to a piece of last year’s tax-code overhaul, which caps a company’s ability to deduct interest expenses at 30 percent of their adjusted income. Previously, corporate interest payments were, for the most part, tax-deductible. This has changed the corporate mindset and prompted companies to consider different options to lower their interest expenses. In fact, based on the numbers, it seems there is an ongoing shift among many companies to issue less debt altogether, a change of course that may continue to restrict the longer-term supply.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. This information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.
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