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AAM Viewpoints – Corporate Credit

We appear to be in the halcyon days of corporate credit quality. Profitability is at record levels while corporate default rates continue to decline and are well below long term medians. Are we nearing the end? Should investors brace for a very sudden end of this very benign place in the cycle that we find ourselves in?

As a brief background, corporate default rates through the end of 2017 continue their decline. According to Moody’s, 90 companies defaulted in 2017 (defaults include bankruptcies, distressed exchanges, and payment defaults), the first time since 2014 that these corporate defaults were less than 100. The U.S. default rate dropped to 3.3% from 5.6% a year ago. This trend is not confined to the United States. On a global basis, the default rate, per Moody’s, dropped to 2.9% from 4.4% a year ago.

The recent precipitous drop in default rates is generally attributable to the increase in oil and gas prices which have strengthened the energy companies, the source of the recent spike in the default rates. But, now that energy prices have generally stabilized, can we expect a resurgence in default rates, or even a stabilization? It appears that the benign environment likely will continue and that default rates could continue their drop, at least through the end of the year.

Corporate Profits:

Although 4th quarter 2017 results are not yet completely in, corporate profits appear to be continuing their surge based on those companies reporting to date. Through the 3rd quarter of 2017, profits are near record highs.

The dip in 2015 -2016 was due to energy-related companies, a situation which has greatly improved since then.

Corporate Liquidity:

One of the reasons for the favorable corporate credit environment is the ease of access to funds for high yield companies to access the markets, heretofore defined as corporate liquidity. On a historical basis, we remain in the halcyon days. High yield option-adjusted spreads remain at levels that are at historical lows, facilitating market access for the weaker high yield companies. As long as these markets remain favorable, liquidity in the corporate market likely will be supportive of credit.

U.S. high yield has had modest setbacks with the recent volatility of the equity markets. But on a historical basis, the environment remains beneficial. Additionally, the U.S. high yield started 2018 with a -34 bps (basis points) January spread rally for the largest spread tightening and absolute spread move since December 2016.

Corporate Leverage:

Corporate leverage is weakening. Global non-financial corporate debt grew by 15 percentage points from 2011 to 2017. The monetary stimulus by the Fed encouraged borrowers to lever up. This would normally be very concerning and possibly be an indicator of the favorable environment coming to an end. But, in our opinion, this is not the case this time around. Improved corporate cash flows have improved debt service coverage ratios over the same time period (2011-2017). This is mitigating the impact of higher leverage. Additionally, this time around, earnings growth has caught up with debt growth since 2016. The continuing recovery in earnings and cash flow could see leverage moderating in 2018, but remain at an elevated level. To summarize, although corporate leverage is something to watch, the rise in corporate profits, cash flows, and consequent improvement in overall credit metrics has tempered the negative impact of corporate leverage.

Source: Standard & Poor’s

The Credit Cycle:

The currently strong credit cycle is mature and some may argue that we are due for a downturn…that we are at the top of the business cycle, with only one way to go: down. It is true that we are at the top of the cycle. Moreover, many central monetary authorities across the globe are starting to moderate stimulus and considering rate hikes to slow things down. Nevertheless, there has been very little indication that basic underlying economic strength is significantly weakening. Moreover, recent tax reform that significantly lowers corporate tax rates, repeals the corporate alternative minimum tax, among other things, will be generally positive for corporate cash flows and overall credit strength. This could act as a shot in the arm to extend the cycle.

The Economy:

Almost all economic indicators for the U.S. economy are favorable. Small business optimism is up, employment data is consistently favorable, GDP (gross domestic product) is expanding, and factory orders exceeded expectations. There are some other indicators that suggest a pause in growth, but overall, the consensus is positive.

Conclusion:

There are many other factors not included here which can serve as an indicator of future corporate strength and defaults. But based on the date that we are looking at, the benign environment of corporate credit has the potential to continue, absent any unanticipated shocks. The corporate default rate also has the potential to continue its descent in 2018.

CRN: 2018-0205-6401 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.