Investment Review and Outlook

Fed initiates interest rate increases to address inflation, while sharpening the tone of its remarks.

On March 16, the Fed increased the fed funds rate by a quarter percentage point, the first such increase in more than three years. The 25bps hike came as the central bank sought to arrest price increases that have reached the fastest pace since the 1980s.

Price inflation reflects a rapid pace of economic growth fueled by government stimulus and product shortages caused by strained global supply chains, both of which can be traced the COVID pandemic. In addition, Russia’s invasion of Ukraine led to shortages in commodities relied upon by the energy, food/beverage, and chemical sectors, among others, prompting further price pressures.³

Less than a week later, Fed Chairman Jerome Powell told the National Association of Business Economics that the Fed was prepared to raise interest rates in half-percentage-point steps—and high enough to deliberately slow the economy—if needed, according to The Wall Street Journal.⁴

After the comments, stocks and government bonds sold off. Many read the comments as being intended to demonstrate the Fed’s resolve to cool both actual inflation and expectations among consumers for future increases. For the quarter, risk assets were volatile, and performance was negative, in some cases, historically negative.

According to Bloomberg, U.S. Treasury Bonds fell 5.58 percent on the quarter, while the broad Bloomberg Aggregate U.S. Bond Index was off 5.93 percent. Equities, as measured by the S&P 500 Index, ended the quarter 4.90 percent lower, the worst quarterly drop for stocks in two years, after being down almost 12 percent earlier in March.

The Bloomberg U.S. Corporate Investment Grade (IG) Index (the Index) spread widened by 23bps between December 31 and March 31. The average spread of the Index closed the quarter at 116bps after reaching as high as 145bps in March. The Index recorded a quarterly loss of 7.69 percent on a total return basis and a negative excess return of 1.45 percent.

While corporate credit fundamentals remain solid, global events and economic trends hold the potential of moderating positive credit rating trends. “The confluence of the Russia-Ukraine military conflict, nagging inflation and the prospects for higher interest rates, and the lingering pandemic mark a turn in the positive credit momentum of the past 14 months,” S&P rating recently reported. “But while downgrades are now outpacing upgrades, ratings remain resilient overall, and pressure is mounting unevenly.”⁵

For the quarter, IG corporate bond issuance pf $508.9 billion, according to Bloomberg data, exceeding the prior quarter’s total of $318.7 billion and falling shy of the $523.8 billion total of the first quarter 2021. IG fund flows reflected the concerns of the investment markets in the inflationary environment, shifting to a total of $28 billion in outflows, as reported by EPFR.

Fundamentals

Interest Coverage and Leverage Metrics Are Well-Positioned

We view the fundamental credit backdrop as stable for IG issuers. Mean interest coverage has improved by two-full turns (from 6.2 times to 8.2 times) as all-in financing rates were low during 2021.⁶

With high cash balances and a recovery in cash flows, IG mean net leverage (for example, debt minus cash dividend by earnings before interest, taxes, depreciation and amortization (EBITDA), improved to 2.66 times at the end of 2021 from 2.84 times at year-end 2020.⁷

Leverage moved slightly higher in 4Q21 as issuers looked to deploy excess cash for cap ex, dividends and share buybacks. We expect that trend to continue, and net leverage has probably troughed. (See Figure 1.)

Earnings Growth and Profit Margins May Have Peaked

After bouncing back from the height of Covid-19 Pandemic lockdowns, corporate earnings grew over 30 percent in 4Q21 year-over-year (Y/Y). Profit growth is projected to slow to about 9 percent in 2022.⁸

Profit margins peaked in 4Q21 and could trend lower through 2022.⁹ Wage and input cost inflation is expected to weigh on margins if issuers cannot fully pass on higher costs to consumers. (See Figure 2.)

IG issuers have minimal direct exposure to the Russian economy¹⁰. Non-recurring write-offs and charges may be incurred but for most issuers that should not drive material credit deterioration.

Technicals

Elevated Supply and New Issue Concessions as Outflows Picked Up

IG fixed-rate corporate supply of $509 billion in 1Q22 was the highest quarterly amount issued since 2Q21. Net supply of $226 billion was moderate due to redemptions and bond tenders.

IG bond mutual and exchange-traded funds experienced net outflows of -$28 billion in 1Q22 as compared to -$5 billion of inflows in 4Q21 and $105 billion of inflows in 1Q21.

IG new issue bond concessions rose to their highest point in recent quarters on elevated supply and fund outflows. Spread concessions can create attractive new issue opportunities. (See Figure 3.)

Valuations

IG Spreads Widened Sharply on Inflation Concerns and Russia

The IG Corporate Index finished 1Q22 at an option-adjusted spread of 116bps or 23bps wider on the quarter. The Russian invasion of Ukraine saw spreads peak at 145bps on March 14, 2022, before retracing.

Historically and on average, following inversion of the 2-year and 10-year U.S. Treasury bond yields, BBB corporate spreads have widened moderately prospectively, but in some cases they have tightened. (See Figure 4.)

We continue to expect volatility and a slight widening bias in IG spreads related primarily to inflation concerns, monetary policy tightening, and prospects of a material slowdown in economic and profit growth during 2023.

ESG Spotlight

Investor focus continued to sharpen during the quarter on the material risks that ESG factors can pose to future corporate performance and the ability of bond issuers to meet their obligations to shareholders.

Climate change remains a central concern among investors, policymakers, and corporate bond issuers. In late February, the Intergovernmental Panel on Climate Change (IPCC), a body of experts convened by the UN, released the most detailed look yet at physical threats posed by global warming. Robert Fernandez, CFA, director ESG Research, and Andrew Teras, director, Municipal Research, discussed the report: Latest IPCC report underscores urgency of climate action for investors and businesses move toward more consistency.

In a related development, the SEC proposed rule changes on March 21 that would require corporations to include certain climate-related disclosures in their registration statements and periodic reports.¹¹ including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.

While climate change, including transitioning to a low- or no-carbon future economy—are prominent themes in ESG investing, a report by S&P Ratings¹² highlights several other themes that are capturing increasing attention among investors, regulators, and others. They include effects of economic activity on natural capital and biodiversity; social issues in corporate operations and supply chain management, including human rights monitoring and reporting, labor conditions, and diversity, equity, and inclusion; divestment and engagement strategies in investing; the sustainable debt market, and net zero investing approaches.

We updated our report on the sustainable debt market in the most recent edition of our ESG Newsletter. A consistent increase in issuance during early 2022 demonstrates the market’s continued favorable view of sustainable bonds. You can learn more about our analysts’ views on this growing market here: Sustainable Bond Issuance Is Growing Across Bond Market Segments

In addition, members of the corporate and municipal bond research teams shared their thoughts on recent developments regarding net zero carbon emissions and net zero pledges. Our article Corporations Sign Net Zero Pledge, But Can They Back It Up? explains what net zero is and how Breckinridge Capital Advisors monitors progress as companies pursue a pathway to towards net zero.

[1] “US Investment Grade Corporate Update”, Barclays Credit Research, April 1, 2022,

[2] “Credit Flows: Supply & Demand”, Wells Fargo Credit Strategy, EPFR, March 31, 2022.

[3] “Federal Reserve announces interest rate hike,” CBS News, March 16, 2022.

[4] “Stocks End Lower After Powell Interest-Rate Comments,” The Wall Street Journal, March 21, 2022.

[5] “Global Credit Conditions: Q2 2022 Confluence Of Risks Halts Positive Credit Momentum,” S&P Ratings, March 31, 2022.

[6] “Investment-Grade Fundamentals: 4Q21”, Bloomberg Intelligence, April 6, 2022.

[7] Ibid.

[8] Earnings Insight, FactSet, April 1, 2022.

[9] Global Credit Trader: Range-Bound Until Further Notice, Goldman Sachs Credit Strategy, March 24, 2022.

[10] U.S. Company Exposures to Russia and Ukraine, U.S. Credit Alpha, Barclays Research, March 18, 2022.

[11] “SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors,” U.S. Securities and Exchange Commission, March 21, 2022.

[12] “Key trends that will drive the ESG agenda in 2022,” S&P Ratings, January 31, 2022.

DISCLAIMER

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.

There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.

Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.

Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.

The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.

Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.

The content may contain information taken from unaffiliated third-party sources. Breckinridge believes such information is reliable but does not guarantee its accuracy or completeness. Any third-party websites included in the content has been provided for reference only. Please see the Terms & Conditions page for third party licensing disclaimers.