Monday Musings: September 20, 2021

Sep 20, 2021

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Public Trust Credit Team
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Evergrande roils markets and keeps companies on the sidelines

According to Bloomberg, at least eight high-grade issuers that had planned to tap the debt markets this week have pulled their deals due to market volatility related to the looming Evergrande default in China. Evergrande, one of China’s largest real estate developers, is facing a cash crunch and will likely default on $300 billion of debt. Investors are primarily concerned with whether or not Beijing will step in to rescue the company or allow it to fail as China struggles to rein in its booming housing market. While a default is unlikely to directly impact any of the Public Trust-approved companies or threaten the U.S. economic recovery, the knock-on effects could be material. A default could lead to a flight to quality and lower liquidity in the debt markets, while the equity market is already feeling the effects of the potential default, and turmoil in the equity market generally precedes a decline in issuance in the debt markets.

Investors have ground spreads down to traditional post-recessionary lows; liquidity remains a top concern

The spread of the ICE BAML Investment Grade index remains around 90 bps, a level normally seen during the end of economic expansions. Investors have ground down spreads in the index as dollars chase any yield available, causing spreads to touch previous lows much faster than usual. However, investors still appear to be worried about liquidity according to research from Bank of America. Off-the-run issues (previously issued debt as opposed to on-the-run issues which are new deals and tend to be more liquid) are trading at a 10% discount to their on-the-run counterparts, particularly in the shorter end of the curve. During the last two times spreads were this tight, the liquidity premium declined to zero, suggesting that despite incredibly accommodative financial conditions, investors are still worried about a liquidity crunch. With the potential of a slower reopening, contagion from other countries (China/Evergrande), and potentially sticky inflation, we expect investors will continue to prize liquidity especially when tight spreads make it tough to be compensated for credit risk.

U.S. investment-grade fundamentals continue to improve

According to a recent report by BofA Securities, U.S. investment-grade (IG) industrial (non-financial, non-utility) gross leverage has improved materially in Q2 2021, essentially declining to levels last seen in Q4 2019 (2.69x). With high cash balances for U.S. IG, net leverage has also declined to levels from Q4 2018 (1.94x compared to 2.18x in 4Q19). In aggregate, the IG industrials benefited from a +8.4% quarter-over-quarter increase in the last twelve months EBITDA in addition to a 2.6% year-over-year decrease in gross debt including both high-grade and BBB issuers. Given the solid level of earnings for U.S. IG issuers, healthy EBITDA generation and cash growth have helped improve credit profiles.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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