Investment Review and Outlook

Going forward, we expect favorable operating, rating trends offset by geopolitical, corporate event risk.

With a larger than expected 50bps cut in the federal funds rate in mid-September, the Federal Reserve (Fed) initiated a monetary policy-easing cycle. With the decision, the Federal Open Market Committee (FOMC) signaled a shift from getting inflation under control to supporting economic growth.

Economic growth has been positive on resilient spending, although labor market data in July and August showed signs of weakening. Barclays reported on October 3, seasonally adjusted initial jobless claims increased 6,000 over the week ending September 28. 

The Fed projects cuts of 50bps by the end of the year. Fed Chair Jay Powell suggested the FOMC could cut rates faster if economic data worsen in the months ahead. 

Based on its September Summary of Economic Projections (SEP), the Fed estimates real gross domestic product (GDP) growth will be 2 percent in 2024 and 2025. Inflation is expected to end 2024 at 2.6 percent and fall to 2.2 percent in 2025.

High profile elections in the U.S., the ongoing and potentially widening Israel/Hamas conflict, and the Russia/Ukraine wars heighten geopolitical risks.

Valuations

Corporate spreads were 5bps tighter in the third quarter, according to BBG data. A-rated and BBB-rated corporate spreads tightened by an average of 7bps and 3bps, respectively. At at an OAS of 89bps on September 30, spreads are in the 8th percentile of their 10-year range.

Relatively compressed valuations argue for a defensive stance. Spreads may drift wider as the lagging effect of the Fed’s multi-year restrictive monetary policy stance further slows U.S. economic growth.

Technicals

Year-to-date through September 30, 2024, gross and net supply are running ahead of the prior year and bond fund inflows accelerated, buoying demand for credit.⁴

Total fixed-rate, gross IG supply in excess of $1.5 trillion through three quarters, already exceeded 2023’s 12-month total issuance of about $1.4 trillion, BBG data showed.

We feel that a resurgence in merger and acquisition (M&A) activity is integral to the issuance of more corporate bonds supporting M&A deals. U.S. M&A were 25 percent higher in 3Q24 year-over-year (Y/Y) and debt-funded deals are re-emerging.⁵

Demand also has remained persistent among funds. Through September 25, $113 billion flowed into long-term taxable bond mutual and exchange traded funds (ETFs) during the quarter, per the ICI.⁶

Non-U.S. investors and insurance companies also continued to add to the IG corporate bond asset class.

Fundamentals

Based on BBG data, we believe corporate fundamentals are stable. Earnings before interest, taxes, depreciation, and amortization (EBITDA) margins are at a multi-year high and operating earnings were up 11-percent in 2Q24 Y/Y. Gross leverage is at the higher end of the range, but lower on a net basis due to high cash balances. Interest coverage has declined of late due to higher financing costs and debt balances. Declining valuations for commercial real estate and loss risks in sub-prime loans present headwinds for financial strength in the Banks sector. 

U.S. IG Agency corporate rating upgrades exceeded downgrades by about 3:1 through 3Q24.

FactSet analysts in aggregate predict the S&P 500 will report year-over-year earnings growth of 11.3 percent in 2024 and 14.4 percent in 2025. If these numbers are the actual earnings growth rates for these years, it will mark the third time in the past 15 years that the S&P 500 has reported two consecutive years of double-digit earnings growth, FactSet said.⁷

Sustainable Spotlight

We view climate change as a material, systemic investment risk—particularly for high GHG emitting sectors—that is impacting financial markets today and will likely accelerate in scale over time. Breckinridge integrates bottom-up climate transition risk analysis and aims to accommodates client requests for managing the climate transition risk of the corporate holdings in portfolios in three ways: 1) through our Net Zero customization, 2) through our fossil-fuel-free customization and additional related screens, and 3) by avoiding investment in the energy sector more broadly. The approaches are summarized in Figure 4. 

The management of climate transition risk in the corporate holdings of our clients’ portfolios follows our longstanding capability to customize portfolio parameters. For more information refer to our recent report, https://www.breckinridge.com/insights/details/breckinridge-s-approach-to-managing-portfolio-corporate-climate-transition-risk-exposure/

[1] The Bloomberg U.S. Corporate IG Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.

[2] Bloomberg Intelligence. Note: IG issuer trimmed mean (Bottom/Top 10%) financial data as of 3/31/24.

[3] Barclays U.S. Investment Grade Corporate Update, September 2024.

[4] Barclays U.S. Investment Grade Corporate Update, September 2024.

[5] Mergers & Acquisitions, North America, 3Q24 by Dollar Value, Bloomberg.

[6] Estimated Long-Term Mutual Fund Flows and ETF Net Issuance, Investment Company Institute, October 2, 2024.

[7] “Analysts Project S&P 500 To Report Double-Digit Earnings Growth for 2024 and 2025,” by John Butters, FactSet, June 21, 2024.

BCAI-10042024-a26kczsr (10/9/24)

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