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Observation Deck: A tale of low rates and corporate credit

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SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy. 

A tale of low rates and corporate credit

Timothy Lee, CFA, Senior Credit Risk & Research Officer

The recent collapse in long-term interest rates has certainly created many choices for corporations. Will corporations’ cash flow climb, as they refinance into historically low long-term rates to reduce interest expenses? Or will corporations pile on debt to buy back shares, dole out dividends or execute mergers and acquisitions? Corporations are now engaged in this internal battle of their own and all this becomes magnified as long-term interest rates have fallen over a hundred basis points (bps) from last year.

Ostensibly, falling interest rates should be good for credit profiles. Fortified revenue and earnings from robust employment and stable macroeconomic conditions, as well as decreased interest payments on debt burdens, are some of the intended outcomes from an easy monetary policy stance enacted by central banks around the world. Corporations stand to benefit from better demand from consumers, who remain emboldened by firm home and equity prices. And in some instances, falling interest rates could even weaken local currencies, which should spur demand from overseas customers. Indeed, low interest rates provide the prudent corporation with the chance to repay outstanding debt, invest judiciously in property and equipment to improve efficiency, and expand operations by cutting the hurdle rate for development projects.

While corporations will want to term out debt, lock in lower long-term rates by converting its floating rate obligations to fixed rates, and use debt wisely to fund investments for future growth, credit investors know that the very same company could be drawn to more thrilling but credit-degrading activities that are afforded by low interest rates.

Indeed, from 2009 through 2016, during a time when the Federal Reserve held overnight interest rates well below 1.0 percent and long-term rates set several record lows, debt levels at S&P 500 non-financial companies marched upward. All this happened while cash was also being used for share repurchases and to pay more dividends.

 

Additionally, higher debt corresponded with rising spending on shareholders, which outstripped spending on capital expenditures beginning in 2010. Depressed interest rates allowed debt to pay for soaring M&A activity, replacing organic growth through capital expenditures with costlier inorganic growth.

 

For banks, lower interest rates and an inverted yield curve may seem to pose an inherent threat, though they often prescribe their own antidote. While net interest margin tends to fall during periods of low interest rates, as deposit and lending margins compress, costs related to defaults and delinquencies could also drop, as asset quality improves in response to easing debt service obligations. In addition, fee income can be fueled by higher volumes of refinancing, credit card transactions and debt originations, and banks will pull other triggers to maintain their credit profiles.

 

Low interest rates also pose hazards to entities with large pension obligations, as the present value of these long-duration liabilities increases and causes pension-funding ratios to drop. Yet low interest rates can also boost the return of risky assets to cushion funding ratios. In addition, lifting corporate profitability can generate more cash to pay down pension obligations. Look for practical management teams to budget cash to their pension accounts to offset the accounting-driven rise in liabilities.

 

Given that the low rate environment looks like it will endure, corporations will be discussing the merits of various financial policies to undertake. There was no singular direction during the last round of low interest rates, as agency credit ratings for S&P 500 companies showed there was nearly an equal distribution of companies that experienced an upgrade, downgrade and no change to their senior unsecured debt rating. Though there was a slight deterioration at the end of 2016, the average rating for the index remained near the Baa1 level that it started with at the beginning of 2009.

 

In managing through the current market environment, we look for companies that prioritize paying down some of the debt they racked up during the last decade of low rates, while also refinancing certain debt into longer term obligations. Large debt-fueled M&A activity should give way to equity-funded M&A and smaller tuck-in acquisitions, as companies look to more surgically enhance their growth prospects. In addition, debt-funded share repurchases should decline in favor of more sensible capital expenditures, particularly technology upgrades that support organic growth and profit margins. For some businesses, the more risky stance may still have the upper hand, as in the situation of many insurance companies that have limited options beyond markedly increasing their risk appetite to solve a widening asset-liability mismatch. With the lower rate environment and potential for companies to adopt new financial polices as a result, our focus remains on identifying and avoiding issuers with increased risk profiles in this volatile market.

 

Economic Vista: Deciphering the data

Steve Johnson, CFA, Senior Portfolio Manager

The economic data has never been trickier to decipher. On the one hand, we have plenty of evidence that suggests the consumer-driven economy is on solid footing, even as some potential cracks appear. On the other hand, manufacturing data is beginning to weaken, perhaps reflecting the uncertainty surrounding the impact of rising tariffs. Ultimately, whether economic growth marches on or stumbles may rest on the resolution of our current trade dispute and the direction of trade policy.

On the consumer front, as has been the case for some time, employment data continues to be a relative bright spot. In line with expectations, nonfarm payrolls rose by 164,000 in July. However, payroll growth was revised lower over the prior two months, bringing the three- and six-month averages to 136,000 and 134,000, respectively. This marked the slowest six-month average since September 2012. Other concerns from the most recent jobs data include the decline in hours worked. The average workweek fell to 34.3 hours from 34.4 hours, and the aggregate weekly hours index fell 0.2 percent as a result. The readthrough becomes that businesses may be holding onto workers in a tight labor market but reducing labor utilization by cutting hours.

Also bear watching, the University of Michigan’s Consumer Sentiment Index declined by 8.6 points to 89.8 in the final August report, coming in below consensus expectations. The headline index now stands at its lowest level since October 2016 and marks the second largest monthly decline since December.

New home sales came in significantly below consensus expectations for July at an annualized rate of 635,000, but concerns regarding a housing slowdown were mitigated, given a sharp upward revision for the prior month. June sales were revised upward to an annualized rate of 728,000, the highest level since 2007. The median sales price decreased 4.5 percent year-over-year to $312,800. In total, this suggests positive momentum in the housing market, driven largely by lower borrowing costs.

July headline retail sales rose 0.7 percent month-over-month, while June sales were revised slightly lower. Excluding autos and gas, retail sales surprised to the upside and increased 0.9 percent in July, with gains broad based in 10 of the 13 major retailer categories.

While the consumer appears to still be carrying the economy, industrial production surprised to the downside, dropping by 0.2 percent month-over-month vs. consensus expectations of a mild increase. The weaker reading for industrial production was driven by lower manufacturing output, which dropped 0.4 percent in July, even as it was revised up slightly in June.

The preliminary US Purchasing Managers’ Index (PMI) data also disappointed across both manufacturing and services gauges, which may portend to slower growth. In fact, the manufacturing reading dropped below 50, which indicates a contraction, for the first time since September 2009. Countering this news, however, was the July National Federation of Independent Business (NFIB) Small Business Optimism Index (SBOI), which surprised on the upside at 104.7. That said, the report provides a sense of how small business owners were feeling about the developments before the latest escalation in trade tensions. Therefore, investors may choose to discount this latest survey.

Finally, real GDP increased at an annual rate of 2.0 percent in the second quarter of 2019, according to the second estimate released by the Bureau of Economic Analysis (BEA). This was a slight downward revision from the first reading of 2.1 percent. At the same time, consistent with previous themes, personal consumption was revised up to 4.7 percent from 4.3 percent in the first reading.

Credit Vista: The port in the storm

Fiona Nguyen, Senior Credit Risk & Research Officer


Amid the noisy backdrop of the US-China trade spat, slowing global growth, a yield curve inversion and fears of a looming recession, it appears that the ever-resilient US consumer trend is the only bright spot in the economic outlook. Several consumer-related data points have reinforced this view, but the question remains: How long can consumers carry the load? 

Following a relatively weak first quarter, consumption rebounded significantly in the second quarter with robust consumer confidence indicators and retail sales growth. In the months of July and August, the consumer confidence index has held strong, topping forecasts for two consecutive months. Another indicator, retail sales data, painted a similar picture with a 0.7 percent month-over-month gain in July, following 0.4 and 0.5 percent gains in June and May, respectively. Reflecting this optimism in the retail space, big-box retailers, such as Walmart, Target, Home Depot and Lowe’s, all reported strong quarterly results and higher guided earnings for 2019.

In case anyone needs a reminder, it’s worth noting that US consumption accounts for more than two-thirds of the economy. At the moment, this big engine is being fueled by positive job creation, wage growth and household spending. The economy continues to add jobs in a tight labor market, albeit at a slower pace, with an average year-over-year employment growth of 1.7 percent. Wage growth is steady, without signs of overheating, currently projecting to an increase of approximately 3.8 percent year-over-year. These factors, together with inflation that is likely to remain subdued through 2019, will be critical if the consumption momentum is to continue.

Besides spurring consumption spending growth, what does all this mean for consumer credit performance? Low unemployment and rising income tend to support household credit strength. Today, the aggregate household balance sheet remains healthy, with leverage (measured as debt-to-assets) standing at low levels. Additionally, household financial obligations, measured as the ratio of household payments to disposable income, continue to hold steady in a supportive interest rate environment.

From the lenders’ perspective, consumer credit quality appears to be solid. The quarterly report from the Federal Reserve on net charge-offs and delinquencies showed asset quality metrics have risen modestly but remained below pre-crisis levels. The slight deterioration in credit card asset quality is a function of normal late-cycle credit expansion, as card lending volume continued to increase in the first and second quarters. At this pace of credit growth, delinquency is bound to rise at some point, but for now it remains tempered and we are largely unconcerned.

On the non-financial corporate credit side, healthy spending trends translate into a rosier outlook for big retailers throughout the rest of the year. Aside from the department stores, which are undergoing secular shift in consumer shopping preference, the overall US retail sector continues to benefit from positive consumer sentiment. The optimism certainly bodes well for solid cash flow generation.

In times of elevated market volatility and continuous global headwinds, robust domestic consumption has become the port in the storm. Until new challenges emerge that curtail consumer spending power, investors might take some comfort knowing this powerful economic engine is still humming.

Trading Vista: Calling the cuts

Jason Graveley, Fixed Income Trader

After the July Federal Open Market Committee (FOMC) meeting followed the expected script with the reduction of the target rate by one-quarter point, the markets yawned and there was little immediate volatility. This changed abruptly, though, as an escalation in the trade war with China blindsided markets. At the same time, growing fears of global weakness prompted other overseas central banks to make their own moves to lower rates. This caused investors to buy into the relative safety (and yield) of US Treasuries. Treasuries reacted in-kind with the spike in demand, and the yield curve saw a stark drop through the first week in August. After closing July at 1.87 percent, the two-year Treasury plummeted more than 30 basis points (bps) during the next week and has since closed as low as 1.47 percent during the month of August.

That’s a significant move, but the fun doesn’t stop there. An additional layer of this volatility comes courtesy of the market’s forecast for future monetary policy. With Federal Reserve Chairman Jerome Powell emphasizing the Fed’s expectation to “act as appropriate to sustain the expansion,” the path of future monetary policy has caused some internal discord at the Fed. At the July FOMC meeting, two Fed presidents dissented from the 25-bps cut, preferring no move at all, while others favored a more aggressive 50-bps cut. Although dissent is not uncommon, this represents an especially wide spectrum of views.

Currently, market participants are expecting a series of cuts, which Chairman Powell has framed as “insurance” and not necessarily the start of a prolonged easing cycle. The future implied probability of another interest rate cut in September is at 100 percent, with the likelihood of a 90/10 split in terms of whether it will be 25 or 50 bps. These probabilities remain fluid, though, as this has shifted from approximately 60/40 earlier this month.

Such uncertainty has weighed on markets, and weary investors have flooded into the front end of the yield curve amid the volatility. As a result, money market fund complexes have seen a significant jump in year-over-year flows, pushing yields lower in the near-term. And while credit spreads have remained range bound as demand stays robust, all-in yields across the curve have reset lower. Given the overall decline in interest rates, we continue to extend duration to lock in meaningful longer-term yields on behalf of clients, while leaving ample liquidity for any immediate cash needs or a backup in rates. 

Markets

Treasury Rates: Total Returns:
3-Month 1.98% ML 3-Month Treasury 0.20%
6-Month 1.87% ML 6-Month Treasury 0.24%
1-Year 1.76% ML 12-Month Treasury 0.25%
2-Year 1.50% S&P 500 -0.70%
3-Year 1.43% Nasdaq -1.69%
5-Year 1.39%    
7-Year 1.45%    
10-Year 1.50%    

Source: Bloomberg, Silicon Valley Bank as of 8/31/19

0919-0126MS-083120

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. Views expressed are as of the date of these articles and subject to change. 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.

None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Asset Management.

SVB Asset Management is a registered investment advisor and nonbank affiliate of Silicon Valley Bank, and member of SVB Financial Group.

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About the Author

Tim Lee, CFA, is a senior credit risk and research practice lead for SVB Asset Management (SAM). In this role, he researches and recommends fixed-income investments in the corporate, municipal, sovereign and securitized product sectors. Tim thrives on learning about and researching a diverse range of investment opportunities. He’s a virtuoso at figuring out how companies operate and how their products work. He particularly enjoys covering the healthcare industry. He is challenged by the complexities of this sector’s new treatments and how to pay for them as well as the ongoing transformation of the healthcare management system.

Before joining SVB, Tim researched and recommended investments for public pension plans at an investment consulting firm. Prior to that, Tim was a senior member of the fixed-income markets practice at Bloomberg L.P., where his focus included macroeconomics and strategies in the interest rate, securitized products and credit sectors. He began his career managing and structuring mortgage-backed securities.

Tim earned a master’s degree in economics and a bachelor’s degree with honors in international relations and economics from San Francisco State University.

Outside of work, Tim loves to travel and has visited all 50 states. He also supports Best Buddies, a nonprofit dedicated to helping people with intellectual and developmental disabilities. He cycled 100 miles on his mountain bike with Team SVB in the Best Buddies Challenge. And lastly, a word of advice: Don’t get into a “my first car was groovier than your first car” contest with Tim. His was a snazzy (for the time) 1979 AMC Concord, a car that continues to hold a special place in his heart.
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