Investment Review and Outlook

Fed interest rate policy turns more hawkish, June fed fund rate increase is largest in 40 years

Continuing its intention to slow economic growth through tighter monetary policies, the Federal Open Market Committee (FOMC) increased the fed funds rate by a quarter percentage point at its early-May meeting.

On May 27, the Commerce Department’s Bureau of Economic Analysis report showed the personal consumption expenditures (PCE) price index, the Fed's preferred inflation indicator jumped 6.3 percent on an annual basis in April, after a 6.6 percent increase in March.

The FOMC responded with the 75bps fed funds rate increase at its June meeting. In comments after the meeting, Fed Chair Powell was clearly focused on inflation control, even if tighter monetary policy might lead to recessionary pressures.
While the root causes of the inflationary environment—price inflation driven by economic growth and fueled by government stimulus, product shortages, and Russia’s invasion of Ukraine—have not changed, talk of a potential recession in the U.S. sent equity and bond markets into another spasm of volatility during the quarter.

According to Bloomberg, U.S. Treasury Bonds fell 3.78 percent on the quarter, while the broad Bloomberg Aggregate U.S. Bond Index was off 4.69 percent. Equities, as measured by the S&P 500 Index, ended the quarter about 16 percent⁷ lower.

The Bloomberg U.S. Corporate IG Bond Index (the Index) spread widened by 40bps between March 31 and June 30, ending the quarter at 155bps. The Index recorded a quarterly loss of 7.26 percent on a total return basis and a negative excess return of 2.24 percent.

While corporate credit fundamentals remain solid, global events and economic trends hold the potential of tilting credit rating trends to a negative posture. “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.”⁸

For the quarter, IG corporate bond issuance was $333 billion, according to Bloomberg data. Net issuance during the same period was $86 billion. IG fund flows reflected the concerns of the investment markets, totaling $32 billion in outflows, as reported by EPFR.

Fundamentals

IG Balance Sheet Strength has Improved Over the Past Year

For IG issuers, for the trailing 12-months earnings before interest, taxes, depreciation and amortization (EBITDA) and total debt growth have averaged 17 percent and 3 percent, respectively.⁹

The recovery in corporate cash flows and earnings drove gross leverage down to 2.1 times from 2.4 times over the past year (See Figure 1).

However, leverage troughed at the end of 2021 and with earnings growth slowing, debt metrics may drift higher prospectively. A drop in merger volumes (down by 17 percent y/y) and a moderation in debt-funded deals is credit-positive and a partial offset to slowing earnings.¹⁰ Supply chain strains, elevated input costs, and labor and wage issues are proving to be stickier than expected and may weigh on profit margins.

IG Rating Agency Outlooks are Tilting Negative After a Positive Period

As the economy recovered, S&P upgraded more IG issuers than it downgraded during 1H22 and in 2021. That posture is shifting.

S&P negative credit rating outlooks and watch-listings are running at nearly 2:1, relative to positive outlooks and watch-listings (See Figure 2).¹¹

With outlooks and watch-listings driving rating changes over time, S&P sees a higher risk of net credit deterioration in the IG sector.

Technicals

IG Supply Underwhelmed as Fund Flows Remained Negative

IG fixed-rate gross and net bond issuance of $333 billion and $86 billion, respectively in 2Q22 dropped from $512 billion and $229 billion in 1Q22.¹²

IG bond funds reported net outflows of $32 billion in 2Q22 compared to $28 billion of outflows in 1Q22 and $74 billion of inflows in 2Q21.¹³

We expect the new issue market to remain choppy until fund flows stabilize and interest rate and spread volatility begin to ebb (See Figure 3).

Valuations

IG Spreads Widened but Remain Tight Compared to Prior Slowdowns

The IG Corporate Index was 39bps wider in 2Q22. Bonds rated A and those rated BBB were 32bps and 50bps wider, respectively.

At 155bps, IG spreads are below peaks experienced during prior post-Great Financial Crisis U.S. economic slowdowns.¹⁴

We continue to expect volatility and a slight widening bias in IG corporate spreads based on inflation pressures, a hawkish Fed, and a slowing economy (See Figure 4).

ESG Spotlight

We continue to see growth in reporting on key ESG issues among the country’s largest corporations. This year, independent research confirmed our observations.

The White & Case Public Company Advisory Group reviewed the annual meeting proxy statements and annual reports of 50 companies in the Fortune 100.¹⁵ In these 100 Securities and Exchange Commission (SEC) filings, White and Case focused on 12 categories¹⁶ of ESG disclosure in annual reports and proxy statements filed with the SEC in 2020, 2021 and 2022.

On March 21, the SEC proposed rule changes that would require corporations to include certain climate-related disclosures in their registration statements and periodic reports (See our Q2 2022 Corporate Bond Market Outlook as well as our ESG Newsletter article SEC Proposes Climate-Related Reporting Requirements). In its survey, White & Case found that climate-related disclosure significantly increased in both Form 10-K and proxy statement filings of the surveyed companies, with many companies including such disclosure for the first time in 2022.

White & Case found the ESG categories with the largest increases in disclosure were environmental matters, human capital management, environmental and social (E&S) targets and goals, corporate culture, board oversight of E&S issues, social impact/community, and E&S issues in shareholder engagement. The findings of the survey indicate to us a proactive approach among the largest corporate filers in considering and addressing key ESG matters, even in advance of SEC-promulgated rules on such disclosure.

[1] “Bonds in line for worst year in decades,” Reuters, June 30, 2022.

[2] Ibid.

[3] “Stocks markets post worst half in over five decades,” The Wall Street Journal, July 1, 2022.

[4] “US Investment Grade Corporate Update,” Barclays Credit Research, July 1, 2022.

[5] EPFR Global, June 30, 2022.

[6] “ESG Disclosure Trends in SEC Filings - Annual Survey 2022” White & Case, June 22, 2022.

[7] “Stocks rally to end the first day of the second half, Dow jumps 300 points,” CNBC, July 1, 2022.

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

[9] Citi Research, Bloomberg. Calculations made on matched sample of 300 U.S. IG non-financial, non-energy issuers, as of June 23, 2022.

[10] Bloomberg, June 30, 2022.

[11] S&P Ratings, July 1, 2022.

[12] Barclays Research, Bloomberg, Citi Research, as of July 1, 2022.

[13] EPFR Global, as of June 20, 3022.

[14] Barclays Live, Credit Suisse, Statista.

[15] Based on rankings from Fortune magazine's Fortune 500 list, the Fortune 100 are the 100 largest public and private companies in the United States based on revenues. The Fortune 100 are a subset of the Fortune 500, derived from a list of companies that operate in the United States and report to federal agencies.

[16] The 12 categories of E&S disclosure in this survey are the following: (1) Board Oversight of E&S Issues; (2) Corporate Culture;(3) Ethical Business Practices; (4) Human Capital Management; (5) Environmental Matters; (6) Social Impact and Community; (7)Political Contribution Disclosure; (8) Supply Chain Management; (9) E&S Qualifications of Directors; (10) E&S Issues in Shareholder Engagement; (11) E&S Goals; and (12) References to Sustainability Reporting Frameworks, including SASB and/or TCFD.

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