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Global Fixed Income

Sector Pulse

Solid Near-Term Fundamentals Creating Pockets of Opportunity in Investment-Grade Corporates

Steven C. Huber, Portfolio Manager
Steve Boothe, Portfolio Manager

Executive Summary

  • While we believe that the U.S. economic expansion is in its later stages, we think that corporate earnings should grow for at least two more quarters, supporting investment-grade corporate debt.
  • We are still finding some opportunities in European banks and energy-related credits despite the broadly elevated valuations in the investment-grade corporate sector.
  • We are also mindful that the wave of new supply as well as mergers and acquisitions in the investment-grade corporate sector are likely to continue in 2018, which could weigh on the broad sector.
  • However, we see the sustainability of the earnings cycle beyond the next two quarters as the main threat to the investment-grade corporate market.

Demand for investment-grade corporate debt remains strong, and investors have been willing to add risk to generate higher returns in a yield-hungry world. While we believe that the U.S. economic expansion is in its later stages, we think that corporate earnings should grow for at least two more quarters. We expect that this near-term profitability and revenue growth, combined with a positive global growth outlook, will support investment-grade corporate debt. However, credit spreads in the sector steadily narrowed through most of 2017, lifting valuations in the broad sector to elevated levels. In this environment, we are still finding some opportunities in European banks and energy-related credits.

We are also mindful that the wave of new supply in the investment-grade corporate sector is likely to continue in 2018, which could weigh on the broad sector. Global corporate investment-grade issuance topped US$2.2 trillion in 2017, the second consecutive year of record annual new supply. We anticipate that the passage of tax reform will create a rush of corporate mergers and acquisitions in 2018, likely pushing new issuance to even higher levels. While low interest rates have encouraged companies to issue more debt, we do not expect that rising rates will deter new issuance. However, if accelerating inflation triggers faster-than-expected normalization of global monetary policy, that could dampen issuance.

Increasing Non-U.S. Bias

In recognition that the U.S. cycle is in its later stages, we favor the prospects for non-U.S. investment-grade corporate debt. In particular, we are finding good value in European banks. We have been developing this theme over the past six months because of our belief that Europe is earlier in its credit cycle than the U.S. and as political risks—the French and Italian elections in particular—across Europe have subsided to some extent. Banks, especially in Spain and Italy, have been a bit behind their U.S. counterparts in terms of recapitalizing in the wake of the financial crisis. However, they are beginning to make substantial progress in cleaning up their balance sheets and eliminating nonperforming loans.

Refocusing on Energy Opportunities

We find energy-related names increasingly attractive, especially midstream and exploration and production companies. These are areas of the energy industry that have experienced significant volatility and where we feel our fundamental research gives us an advantage in terms of long-term security selection. In midstream, our ability to anticipate changes to corporate structure and financial policy has been crucial, especially over the past year. We do not take outsized risks, but we have found that this area still offers some value relative to other sectors.

Mergers Could Generate Oversupply

We expect to see an increase in merger activity over the next 12 to 18 months by companies that had postponed action until the passage of tax reform. While we are unsure if volumes will be comparable to what they were in 2016 and 2017, we believe that tax reform, strong global growth, and low volatility create a positive environment for merger activity. As a whole, merger activity is a negative for the investment-grade corporate sector as it means that companies are more leveraged and there is more debt in circulation, although some corporations are wary about adding too much debt to their balance sheets.

However, the government regulation of announced deals has not been as friendly as we would have expected it to be under a Republican administration. For example, the Department of Justice surprised many investors by challenging AT&T’s US$85 billion purchase of Time Warner, arguing that the combination of one of the country’s largest telecommunications companies with one of the largest media firms would limit competition. While the uncertainty of this regulatory environment can obviously cause price disruptions and volatility, we are treading lightly in industries where deals have become common, including pharmaceuticals and technology, media, and telecommunications.

Earnings Outlook Key Risk for Investment-Grade Corporates

While we are cautious about the potential for a flood of new supply in some industries, we see the sustainability of the earnings cycle as the main threat to the investment-grade corporate market. While the next two quarters look healthy, the medium- and long-term outlook is more uncertain. While we expect earnings to keep growing, they are likely to grow at a slower pace.

Macroeconomic factors could also threaten the sector’s performance. An unexpected acceleration or deceleration in inflation could pose a risk as it would create uncertainty about the Federal Reserve and monetary policy and could, in turn, trigger a widening in credit spreads. The synchronized global growth story could also fall apart if Chinese or European growth falters or trade wars develop as a result of protectionist U.S. policies. While political tensions can cause bouts of risk aversion, we think that the sector would largely shrug off geopolitical issues, as we saw in the aftermath of Brexit and the Catalan independence vote in Spain—assuming that the global economic backdrop remains strong.

Yield Spreads Over Treasuries (basis points)

January 31, 2008–January 31, 2018

Sources: High Yield Corporate—J.P. Morgan Global High Yield Index, EM Debt Dollar—J.P. Morgan Emerging Markets Bond Index Global, U.S. Corporate Investment Grade—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index.*
Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright 2018, Bloomberg Index Services Ltd. Used with permission.
Yield spreads over Treasuries are the calculated spreads between a computed option-adjusted spread index of all bonds in a given rating category and a spot Treasury curve.
* Option-adjusted spread for the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index as of January 31, 2018. Spread-to-worst for the J.P. Morgan Global High Yield Index as of January 31, 2018.

Relative Value Short-Term Outlook Sector Returns
(As of January 31, 2018)**
Sector Driver One-Mo. Return YTD Return One-Yr. Return
U.S. Treasuries Decent strength to the economy and the Fed continuing on a path of gradual rate hikes suggest higher yields; however, the Treasury market has largely priced in these risks. Inflation expectations and growth momentum will determine the path of interest rates going forward. -1.36% -1.36% 0.69%
U.S. Treasury Inflation-Protected Securities (TIPS) Despite recent softness in inflation data, we expect to see higher breakevens as inflation data appear to have bottomed and oil prices remain supportive. -0.86 -0.86 1.27
Global Sovereign ex-U.S.† We expect developed market yields to increase through time as global growth momentum continues. The improving European economy and gradually rising inflation are convincing the European Central Bank (ECB) to slowly normalize monetary policy. Meanwhile, the Bank of Japan remains highly accommodative despite positive economic data, and the UK will need to raise interest rates, albeit gradually, as long as political uncertainty associated with Brexit remains under control. 3.03 3.03 11.77
U.S. Municipals Municipal yield ratios versus Treasuries remain rich in the short and intermediate section of the curve. Favorable supply/demand dynamics in the sector are expected to continue, and the impact of tax reform is yet to be determined. -1.18 -1.18 3.52
Mortgage-Back Securities (MBS) The outlook for agency MBS has become less favorable, as tight nominal and volatility-adjusted valuations to Treasuries provide fewer opportunities for additional tightening, particularly if volatility picks up. Also, portfolio runoff from the Fed and a stronger seasonal housing environment could increase net supply in 2018. -1.17 -1.17 1.31
Commercial Mortgage-Backed Securities (CMBS) Credit fundamentals in the CMBS sector are largely benign, and from a technical perspective, recent robust issuance has been well received. -1.09 -1.09 1.61
Asset-Backed Securities (ABS) The ABS sector continues to benefit from strong consumer fundamentals and should continue to provide a relative safe haven if interest rate volatility increases. -0.29 -0.29 1.04
Global Investment-Grade Corporate Supportive fundamentals outweigh tight valuations in the sector. ECB tapering could put some pressure on European corporates as support for the sector is gradually reduced. -0.96 -0.96 5.08
Global High Yield Corporate Despite rich valuations in the sector, high yield continues to be supported by continued investor demand for yield, a solid macro backdrop, rising oil prices, and strong company earnings. Potential risks include volatile commodity prices, outflows, weakness in equities, and corporate credit being late in the cycle. 0.67 0.67 7.40
Bank Loans Bank loans, with their floating rate feature, appeal to investors seeking shelter from rising interest rates. Solid fundamentals, low commodity exposure, low default rate expectations, and continued strong demand lead us to be constructive on the sector, but a reversal in technicals is a key risk. 1.01 1.01 4.76
Emerging Markets (EM) Dollar Sovereigns Despite inflows into the sector, we are cautious on emerging markets as the Fed may need to tighten further, with three to four hikes expected in 2018 amid higher inflation and tight labor markets. In addition, we are selective in the sector due to rising idiosyncratic political risks (e.g., Mexico, Brazil, Turkey, and Russia). -0.20 -0.20 7.56
EM Corporates Despite a supportive technical backdrop and rising oil prices, we are cautious in the near term given the extent of the sector’s rally, weaker liquidity profile, and little buffer for idiosyncratic shocks. 0.07 0.07 6.71
EM Local Although we continue to favor countries in interest rate-cutting cycles or that offer high real yields, idiosyncratic risks in the sector and the potential for additional Fed tightening lead us to be cautious. Strong inflows, stability in China, and rising oil prices have also supported the sector but provide uncertainty should these factors reverse. 4.48 4.48 17.72

Sources: T. Rowe Price, Bloomberg Barclays, J.P. Morgan, and S&P/LSTA.
** U.S. Treasuries—Bloomberg Barclays U.S. Treasury Index, U.S. TIPS—Bloomberg Barclays U.S. TIPS Index, Global Sovereign ex-U.S.—Bloomberg Barclays Global Aggregate ex-U.S. Index, U.S. Municipals—Bloomberg Barclays Municipal Bond Index, MBS—Bloomberg Barclays U.S. MBS Index, CMBS—Bloomberg Barclays U.S. CMBS Index: ERISA Eligible, ABS—Bloomberg Barclays Asset Backed Index, Global Investment-Grade Corporate—Bloomberg Barclays U.S. Corporate Investment Grade Bond Index, Global High Yield Corporate—J.P. Morgan Global High Yield Index, Bank Loans—S&P/LSTA Performing Loans Index, EM Debt Sovereigns—J.P. Morgan Emerging Markets Bond Index Global, EM Corporates—J.P. Morgan CEMBI Broad Diversified, EM Local—J.P. Morgan Global Bond Index—Emerging Market Global Diversified.
†European corporates are included in this sector.
Past performance is not a reliable indicator of future performance.

Key Risks—The following risks are materially relevant to the strategies highlighted in this material: Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates, which may affect the value of an investment. Returns can be more volatile than other, more developed markets due to changes in market, political, and economic conditions. Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default, which may affect the value of an investment. Investments in high yield securities involve a higher element of risk.

Important Information
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

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