US Credit Update – Investment Grade Lagging

Highlights from U.S. credit markets last week:

  • Investment grade lagging, utilities underperforming
  • CVS borrows $40 billion for Aetna purchase
  • High yield recovery intact but loans still attractive
  • Financials Still Outperforming

Investment grade lagging, utilities underperforming

Risk assets clawed their way higher last week while safe assets slipped. High yield continues to solidify its recovery but investment grade credit has yet to see a bounce. The Bloomberg Barclays utility index is now worst performer across the past week, month, and three months.



CVS borrows $40 billion for Aetna purchase

A larger than normal dose of primary market activity may have contributed to the weakness in investment grade credit. CVS made a move to finance the bulk of its acquisition costs for Aetna, bringing a $40 billion package (WSJ story here). Our corporate desk had the following comments on the week.

Credit volumes were below average this week despite it being a good week for equities. US stocks closed the week +2.8-4.2% while the CDX indices were little changed. Primary issuance eclipsed $57 billion, though $40 billion of that came from CVS funding their purchase of AET. The 9 tranche, $40 billion CVS deal came in as one of the largest ever. It was priced at a significant concession to outstanding paper, which has been the norm for deals of this size over the past few years. The $8 billion 30-year tranche was the best performer, tightening 20 basis points. That amounts to $31,000+ per million bonds. The 10-year tranche proved to be the worst performer, only tightening 8 basis points. The total purchase price of AET was $69 billion, so it is possible that we see CVS come to market at a later date with another $10+ billion transaction.

CI announced they plan to acquire ESRX for $54 billion. ESRX spreads moved 2-5 basis points tighter. ESRX 3.4 3/27 went out +134/130. It was a lackluster performance for the US financial sector. BAC priced $2.35 billion of a perpetual NC10 at 5.875. The issue closed +$0.25. Domestic senior paper closed 1-3 basis points wider and volumes were below normal. 

High yield recovery intact but loans still attractive

Now a full month removed from the February volatility spike, the Bloomberg Barclays U.S. high yield total return index has recovered nearly 1%. Meanwhile, the U.S. investment-grade total return index is drifting lower and at its lowest levels since last June.

This is not necessarily a surprise with Treasury yields still creeping higher. The scatter plot below is similar to the charts above for financials, industrials and utility performance. The charts show z-scores, or standardized 22-day changes, for the U.S. Treasury index (x-axis) and the spread between z-scores for high yield and investment grade (y-axis). The stronger correlation with Treasuries works against investment grade credit here, pulling total returns lower even if spreads narrow. Given the broad shift away from U.S. corporate bond exposure we’ve highlighted in recent weeks, we’re curious to see whether investment grade is able to narrow this gap if Treasuries rebound.

Financials Still Outperforming

Financial sector outperformance is to be expected with Treasury yields still creeping higher. And as we discussed in recent weeks, part of the story is the typically longer duration for industrials and utilities. As long and Treasuries are under pressure, shorter duration financials will tend to outperform both utilities and industrials. But utilities have a much cleaner tendency to outperform financials when Treasury yields fall. Industrial performance relative to financials has been much more erratic.

The chart below shows rolling monthly z-scores, or standardized changes, in the total return indices for U.S. Treasuries on the x-axis. The y-axis shows the spread between z-scores for Financials and Utilities (left) and the spread between financials and industrials (right). Data is from 2010 to present. Note how the distribution of the spread between financials and utilities is tighter than the distribution of the industrials spread, especially as Treasury returns turn positive (lower right quadrants).

Below are the average year to date total returns for industry groups within the Bloomberg Barclay’s U.S. Financials index. The chart on the right shows average total return by average duration. Banks, the largest sector by weight, remain in the middle of the pack on a total return basis for the year at -2.1%.

On a spread basis, banks continue to outperform and especially at longer durations. The next chart shows the average change in spread to Treasury last week, by 2-year duration bin, Bank paper (dark blue marks) was near the top for most duration bins. Spread performane for banks improved for the longest maturities.

The last chart is the same as above but shows average changes in spreads for select subindustry groups last week. Diversified banks outperformed in the middle of the curve where commercial banks saw spreads leak wider by 2-3 bps. Longer-dated commercial bank issues tended to outperform, however.

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