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Mark Kiesel
U . S . C R E D I T P E R S P E C T I V E S
January 2010
Picking the Winners
What will be the investment winners in 2010? A number
of corporate bonds are likely to be winners: They should
outperform Treasuries in 2010 due to improving credit
fundamentals and strongly supportive credit market
technicals, in which demand should exceed supply, causing
credit spreads for many higher-quality corporate bonds to
tighten versus Treasuries. Within the credit market, select banking and financial
sector bonds stand out as potential winners due to an improved outlook for asset
quality and profits; healthier balance sheets; continued government, policy and
regulatory support and attractive relative valuations.
The search for yield, which we claimed would lead to strong relative performance
in the credit market in 2009 (see the December 2008 US Credit Perspectives:
“Credit Now, Equities Later”), will likely continue to influence investment returns
in 2010. While investments in the credit market have performed well in the past
year, corporate bonds, particularly those in certain banks and financials, remain
attractive relative to other fixed income sectors such as mortgages and Treasuries.
The corporate sector has demonstrated remarkable discipline, cutting costs
and spending to increase free cash flow while strengthening balance sheets by
terming out near-term debt maturities with longer-maturity new bond issues
and by raising new equity capital. Credit fundamentals should improve as the
economy gradually recovers, and market technicals appear highly supportive for
corporate bonds, particularly relative to Treasuries.
Credit Fundamentals Improving
Corporate credit fundamentals have improved with the return of private capital
and management’s desire for less aggressive business and financial profiles.
Rising cash balances, stronger balance sheets, an improving economy and easier
credit conditions are all helping to support corporations.
One reason corporate fundamentals and balance sheets are improving is the
return of animal spirits and private sector risk capital in both the equity and debt
2
U . S . C R E D I T P E R S P E C T I V E S
markets. Low short-term interest rates combined
with a gradual economic recovery have caused
investors to venture farther out the risk spectrum
over the past year. According to a December report
from JPMorgan, US companies in 2009 were able
to raise $529 billion of new equity: a 42% increase
over 2008’s total of $372 billion.
In addition to raising equity capital, investment
grade and high yield companies raised $1.18 trillion
through the new issue corporate bond market
in 2009, according to CreditSights. Amazingly,
issuance increased significantly across all rating
categories from AAA-rated to CCC-rated credits,
allowing both high-quality and low-quality
companies to refinance near-term debt maturities
with longer-maturity debt, push out the average
maturity profile, reduce liquidity risk and
strengthen balance sheets.
This improvement in corporate credit fundamentals
has materially improved the outlook for default
risk, particularly in the high yield market, and
increased balance sheet strength and financial
flexibility for corporations. As a result, Standard &
Poor’s is now upgrading more companies than it is
downgrading (Chart 1).
Corporate executives’ confidence has increased
with the improvements in balance sheets, credit
availability and credit fundamentals, along with
the gradual strengthening of the global economy.
Nevertheless, management remains conservative
on the outlook for sustainable economic growth,
as government and monetary stimulus may
fade throughout 2010. The longer-term economic
outlook remains unclear, causing management to
remain highly cautious about hiring and capital
spending. This explains why companies are
hoarding cash: According to JPMorgan, non-
financial corporations, which from 2004–2008
held roughly $500 billion of cash on their balance
sheets, increased their total cash holdings to
$708 billion by the end of the third quarter of 2009.
Although corporations remain conservatively
managed, corporate profits are increasing with the
moderate economic recovery (Chart 2). And, because
US Corporate Pro�ts Improving
Bill
ions
of D
olla
rs
Source: Bureau of Economic Analysis
Chart 2
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Non-financial
Financial
Non-financial and Financial Corporate Profits
Rat
io o
f Upg
rade
s to
Dow
ngra
des
(Inv
estm
ent G
rade
and
Hig
h Y
ield
Cor
pora
te B
onds
) Credit Fundamentals Continue to Improve
Source: Standard and Poor’s
Chart 1
S&P Upgrade to Downgrade Ratio
0.0
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hiring and capital spending are restrained, US
corporate free cash flow is improving significantly.
As a result of cost cutting and aggressive expense
control, non-financial corporations are now
generating free cash flow equal to 29% of EBITDA
(earnings before interest, taxes, depreciation and
amortization), the highest level in a decade
3
according to a December report from Goldman
Sachs. In addition, corporate profits should
continue to improve as credit conditions ease
(Chart 3). A December global survey by McKinsey
cash on corporate balance sheets may be directed
toward more shareholder-friendly initiatives such
as increased dividends or share buybacks. Mergers
and acquisitions (M&A) will likely rise in 2010,
and bondholders will need to be on the lookout
for management teams who appear likely to make
changes to benefit shareholders.
Corporate Bond Market Technicals Supportive
Both financial and non-financial debt growth is
now declining on a year-over-year basis, while the
federal government’s debt growth is rising by 30%
year-over-year (Chart 4). Non-financial corporates
Corporate Pro�ts Should Improve as Credit Conditions Ease
Source: Bureau of Economic Analysis and Federal Reserve
Chart 3
Non
-fin
anci
al P
rofit
s, Y
ear-
Ove
r-Ye
ar %
Cha
nge
% o
f Ban
ks T
ight
enin
g C
omm
erci
al
and
Indu
stria
l Loa
ns (
Inve
rted
)
Pro�ts vs Lending
-30%
-20%
-10%
0%
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20%
30%
40%
50%
60%
1Q 9
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-50%
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0%
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Non-financial ProfitsBanks’ Willingness to Lend
Year
-Ove
r-Yea
r % C
hang
e
Year
-Ove
r-Yea
r % C
hang
e
Corporate Sector Delevers While the Federal Government Re-levers
Source: Federal Reserve
Chart 4
-10%
-5%
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-5%
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40%
Non-financial CorporateFinancial CorporateFederal Government
Non-financial, Financial and Federal Government Debt
need less capital because cash on their balance
sheets is rising: According to JPMorgan, their cash
levels increased by $113 billion in the third
quarter of 2009, as cash flow significantly exceeded
capital spending. As the corporate sector delevers
while the federal government re-levers, bond
market technicals should increasingly turn
positive for corporate bonds and negative for
Treasuries. This will probably be the single largest
factor in credit spreads tightening this year for a lot
of companies.
suggests that increased availability of credit is
leading to a more bullish outlook and greater
confidence in companies’ strategic planning and
budgeting processes. If so, increased hiring and
spending may be on the horizon, which could
help improve the outlook for a sustainable
economic recovery and a continued improve-
ment in credit fundamentals.
The outlook for positive credit fundamentals is not
without risks. The economy is highly dependant on
monetary and fiscal stimulus, as both consumers
and businesses are continuing to delever. Private
sector final demand needs to strengthen before
a sustainable recovery can establish itself. While
near-term inflationary pressure appears under
control, the Federal Reserve may have to tighten
monetary policy should inflationary expectations
rise. Aggressive Fed tightening would slow
economic growth and be a negative for risk assets,
including investment grade corporate bonds, high
yield bonds and equities. Finally, the surge in
4
U . S . C R E D I T P E R S P E C T I V E S
Who’s buying Treasuries? Despite rising issuance,
almost half of the increase in Treasury supply
of $1.89 trillion over the past 12 months, or
$889 billion, was purchased by non-US investors.
Will foreign investment continue to support
the Treasury market to the same degree in
2010 in the face of rising issuance? The answer
remains unclear, particularly given the low
level of Treasury yields and upcoming surge in
government borrowing.
Net fixed-rate Treasury issuance this year should
approach 10% of nominal GDP. By comparison,
net non-financial corporate bond issuance will
likely be less than 1% of nominal GDP (Chart 5).
The amount of Treasury issuance is rising sharply
as the government levers up its balance sheet,
while the amount of non-financial corporate
debt issuance is falling as companies delever.
The Treasury is also set to lengthen the maturity
profile of its debt. Rising deficits are causing
heightened concern over the sovereign credit
risk of the US government. These trends should
support corporate bonds relative to Treasuries in
2010, particularly given that the Federal Reserve
is set to end its quantitative-easing Treasury
and mortgage purchase program in March 2010.
Finally, corporate America’s rising cash balances
and diminished leverage should support credit
technicals due to lower corporate issuance needs,
helping to tighten credit spreads versus Treasuries
for the stronger companies this year.
Bank Bonds Likely to Be Winners in 2010
Within the credit market, the banking sector stands
out as a likely winner. Banks should see a gradual
slowing in the growth of problem loans as well
as improving balance sheet strength and profit
growth. Banks are delevering their balance sheets,
raising more loss-absorbing equity capital and
facing increasing regulatory oversight. In addition,
bank and financial companies should benefit
from reduced issuance needs in the bond market,
providing for supportive market technicals. All
these factors should support bondholders and lead
to strong relative performance.
Banks’ asset quality, while still deteriorating, is
benefiting from government efforts to support
housing. While commercial real estate likely has
more downside risk, there is increasing evidence
that lower-priced housing is starting to stabilise
due to low mortgage rates, government efforts to
increase credit availability to homebuyers and
improved affordability. As residential real estate
prices stabilise and other asset price declines
moderate, the pace of write-downs on banks’
balance sheets should slow. This will likely
improve bank asset quality and earnings and
lessen the need for banks to raise more capital.
Banks’ balance sheet strength and equity
capitalisation have improved significantly over
the past year. The Troubled Asset Relief Program
(TARP) allowed banks to raise equity capital
Technicals Favor CorporateBonds Over Treasuries
Net
Fix
ed-R
ate
Issu
ance
% N
omin
al G
DP
Source: Barclays and PIMCONet fixed-rate issuance is gross fixed-rate issuance minus maturities. Corporate net issuance is non-financials.
Chart 5
-4%
-2%
0%
2%
4%
6%
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10%
12%
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F
Treasury/GDPCorporate/GDP
Treasury vs Corporate Supply
5
when the capital markets were frozen in autumn
2008. However, starting in the fourth quarter of
2008, private investors gradually became more
comfortable taking both subordinated debt and
equity risk in banks and financial companies.
JPMorgan, Goldman Sachs, Bank of America and
Wells Fargo have all been able to sell stock to the
private sector to help raise money to pay back the
government. Just two weeks ago, Citigroup was
able to raise $17 billion in common equity.
The return of private capital has been a significant
positive for the sector. Today, over half of the
government’s $245 billion TARP capital has been
repaid with private sector capital, and in the past
15 months, the over $1 trillion raised across the
worldwide financial system has significantly
exceeded write downs or losses of $743 billion
(Chart 6), according to Bloomberg. As a result of
likely to ensure banks maintain adequate levels
of loss-absorbing equity capital. This is positive
for bonds, which are at the top of the capital
structure, but less so for equity, which potentially
could see further dilution if economic growth
and asset prices deteriorate, leading to loan
losses and additional write-downs. However,
should the economy continue to improve, banks’
profit growth could rebound more sharply than
expected. Finally, the steep yield curve is a positive
for economic growth and specifically for banks
(Chart 7), as net interest margins tend to widen,
which helps boost banks’ profits.
Chart 6*Capital raised and losses announced quarter to date.Source: Bloomberg
Bill
ions
of D
olla
rs
LossesCapital Raised
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The Financial Sector is Re-capitalisingWorldwide Financial System Losses and Capital Raised
3Q 07 4Q 07 1Q 08 2Q 08 3Q 08 4Q 08 1Q 09 2Q 09 3Q 09 4Q 09*
Chart 7Source: Bloomberg and S&P
Yie
ld C
urve
10-Y
ear
Tre
asur
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Fed
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ds (
%)
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P 5
00 C
omm
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ank
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Yield CurveBank Stocks
Yield Curve vs Bank Stocks
Bank bonds continue to offer attractive relative
value (Chart 8) within the overall corporate bond
market. In addition to attractive valuations, bank
bonds benefit from considerably strengthened
balance sheets, the increase in loss-absorbing
common equity, and regulatory efforts to help
cushion balance sheets and protect bondholders
from potential asset quality deterioration.
Finally, and most importantly, governments and
policymakers remain committed to supporting key
banks and financial companies, in order to enable
a sustainable economic recovery.
recent equity issuance, several of the largest US
financial firms saw their Tier 1 common equity
ratios recently climb above 7%, according to
PIMCO credit research.
Increased regulation in the banking industry
will likely mean less leverage and lower returns
on equity. Policymakers and regulators are
6
U . S . C R E D I T P E R S P E C T I V E S
What do market technicals look like for the
financial sector in 2010? JPMorgan estimates gross
issuance in the sector will decline 38% this year
versus 2009, down to $285 billion; net issuance, or
gross issuance minus maturities, is estimated to
decrease by $17 billion (Chart 10). Why do banks
and financial companies need less money? These
companies raised substantial equity over the past
year, were able to access the Temporary Liquidity
Guarantee Program (TLGP) for funding, have now
delevered their balance sheets, remain cautious on
new loans and, if needed, can tap into their vast
Without a healthy financial sector, capital may not
recirculate into the private sector. Governments
and central banks will likely want to ensure the
banking industry is able to increase lending to the
private sector, so government support programs
should remain in place until banks heal. The
Federal Reserve will likely keep monetary policy
highly accommodative to allow banks to increase
profits and build equity capital.
Investing in banks is not without risks. A weak
economy or double-dip recession would be highly
negative for both residential and commercial real
estate prices, and thus for banks’ asset quality.
Higher short-term interest rates, which could
result from the Federal Reserve increasing the fed
funds rate to tame inflationary expectations, would
negatively impact banks’ net interest margins and
profitability. Regulatory and legislative actions
could also be negative for bank investments at the
bottom of the capital structure; re-regulation and
the eventual implementation of Basel III and new
capital rules by 2012 may cause banks to raise more
equity capital, lowering the potential returns for
existing shareholders.
While potentially dilutive for bank shareholders,
re-regulation and increased capital requirements
will likely result in banks that are less risky
and less leveraged. These secular trends, while
likely negative for equity holders, are positive for
bondholders. In fact, both senior and subordinated
debt and even some Tier 1 bank capital could
benefit – such securities are unlikely to be useful
for regulators wanting higher loss-absorbing
capital. The larger equity cushion for bondholders
would likely help tighten credit spreads for bank
bonds. Given the current attractiveness of some
Tier 1 bank capital credit spreads (Chart 9), a select
group of these securities could be relative winners
in 2010.
Opt
ion-
Adj
uste
d S
prea
d (O
AS
) vs
. Tre
asur
ies,
in B
asis
Poi
nts
Opt
ion-
Adj
uste
d S
prea
d (O
AS
) vs
Tre
asur
ies,
in B
asis
Poi
nts
Chart 8
BanksCorporates
Source: Barclays (Sub-sectors of the Barclays US Credit Index)
Bank Bonds Continue to Offer Attractive Relative Value
Corporate Spreads
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Chart 9Source: JPMorgan and BofA Merrill Lynch
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T1 Index
U.S. HY BB-B index
Tier 1 Bank Capital Remains Attractive
JPM
orga
n B
ank
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ital I
ndex
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tion-
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just
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read
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easu
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asis
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erril
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ch U
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Y B
B-B
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x, O
ptio
n-A
djus
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ead
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S)
vs T
reas
urie
s (in
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is P
oint
s)
Bank Capital vs High Yield
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7
regulation requiring higher equity capital, bond-
holders in a number of key bank and financial
companies should benefit as the economy recovers
and profit growth allows capital to build, causing
banking and financial sector credit fundamentals
to improve. Given supportive fundamentals and
a positive technical outlook, investors should
consider staying overweight select bank and
financial bonds and underweight Treasuries in 2010.
Mark Kiesel
Managing Director
Chart 10
Source: JPMorgan
-100
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010F
$ in
Bill
ions
Gross Net
Net issuance is gross issuance minus maturities.
Financial Supply
Technicals for the Financial Sector Are Strongly Positive in 2010
deposit bases for cash. The net result is that the
supply outlook for banks and financials should
be muted this year, providing a positive technical
backdrop for bondholders, particularly given the
likelihood for continued solid demand for high-
quality bonds with attractive relative valuations.
Picking the Winners
The corporate sector is delevering at the same
time the federal government continues to re-
lever. Credit fundamentals are improving
for the corporate sector at the same time
credit fundamentals are deteriorating for the
government. This should lead to tighter credit
spreads, particularly for firms with strong credit
fundamentals, as the beginning of 2010 sees a lack
of high-quality spread alternatives to compete with
corporate bonds.
A number of bank and financial companies
stand out as potential winners this year due to
attractive valuations and an improved outlook for
asset quality and profitability. The banking and
financial sector has been able to recapitalise and
delever its balance sheet by raising private equity
capital. Due to supportive monetary and fiscal
policy combined with the likelihood for increased
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