Stewart: Investment grade corporate credit, that’s the topic of the day. My name’s Stewart Foley, I’ll be your host. This is the InsuranceAUM.com podcast and I’m joined today by Matt Daly at Conning, Head of Corporate and Municipal Teams. Matt, welcome.
Matt: Thanks, Stewart. Thanks for having me. Great to talk with you today.
Stewart: I can’t wait for this. I love investment grade fixed income. I was an investment grade fixed income geek for many, many years and I’m thrilled to talk about this topic, but before we get going, I have to ask you the question I ask everyone, which is, what’s your hometown? What’s your first job? And what’s a fun fact?
Matt: Okay. I’ll start where I’m from, hometown is, I consider it to be Malvern, Pennsylvania. I was actually born in Delaware, but moved to Pennsylvania when I was young, so I do consider that to be the hometown. And then first job I would say, I’d mention two of them. The first job was painting high school college, which taught me a lot about how hot a job can be when you’re up on a roof in the Pennsylvania summers. And then post-college, it was at a bank that no longer exists in New England in the asset-based lending group, going out and kicking the tires of small middle-market borrowers throughout New England and checking on their collateral for the bank. So, that provided a real in-depth perspective as to how companies operated. And then for my fun fact, and I’ll loop back where I was raised in Pennsylvania, my fun fact about myself is I am an avid Philadelphia sports fan. And it’s been a fun time for that.
Stewart: Wow, you’re in good shape right now. Never better, right? It’s all good.
Matt: I am right now. Yeah, Philly’s almost did it in the World Series, Eagles are having a great year. I’m confident the Sixers will turn it around. And I’ve tried to raise my kids, although we’re in central Connecticut, to raise them to be similar Philadelphia fans and I’ve been pretty successful.
Stewart: That’s good. I mean, success with the kids is good. That’s a good fun fact. All right, so let’s start it off. Negative yielding sovereign debt, a rarity up until the 2010s, reached a peak of something on the order of 18 trillion, pretty much gone now. What’s the story around sovereign debt?
Matt: Sure. So, as you mentioned, it did peak, I think it was just over 18 trillion, and this was just two years ago. This was the end of 2020. And that spike obviously followed the COVID-related shutdowns, the sudden closure of economies, governments trying to support their economies. And amazing, it more than doubled an amount from March to December of 2020. So, more than doubled. And then that dynamic, it’s changed just remarkably really over the course of this year, we entered this year, there was about, I think just over 11 trillion of negative yielding debt. And that stands at less than two and a half trillion last time I checked. So, that obviously reflects a shift in central banks that are now focused on inflation, raising rates. So, monetary policy, it’s gone from ultra-accommodative to now much more balanced.
And this has had major implications for the investment grade corporate bond market, when rates were super low, investors were encouraged to reach for yield to push out the risk spectrum, and that benefited all risk assets that includes corporate bonds. So, that’s suppressed rate environment equated to a reach for yield, and as I mentioned, that’s dramatically shifted. Now, for the insurance industry, the industry’s been waiting a long time for yields in this type of zip code, so it’s finally providing some yield relief. The corporate index is an example, it now offers an all-in yield as of this morning just below 6%. So, that’s been a big shift. And you really need to go back to before the great financial crisis to find yields at these type of levels on a sustained basis.
The challenge though for the industry is large unrealized loss positions in investment portfolios due to those backup and rates. And then there’s also concerns about the vibrancy and resiliency of the economy as well as the possibility, and we’ve done a lot of analysis and discussion inside of Conning, as to whether we’re at an inflection point in terms of credit conditions.
Stewart: Yeah. And I mean, I talked to a lot of CIOs, and I hear people talking about a much improved relative value position in public securities versus private. And as you mentioned, just a year ago, I moderated a panel for CFA in New York, and it was all about where am I going to find yield? Where am I going to find yield? And certainly, that conversation has changed. And so, the universe of low-yielding debt made positive-yielding corporate bonds attractive for global investors. That seems to have changed. Can you talk a little bit about the dynamic there of the demand from global investors in our corporate space?
Matt: Sure. So, that’s definitely changed and that’s been a significant technical headwind for the market. So, as we just discussed that the U.S. investment grade corporate market, it was a huge beneficiary of the low-rate environment and now we’ve really shifted gears here. And if you think about total returns, I mean absolutely awful, on a year-to-date basis, minus 20% for the investment grade corporate index. And there hasn’t been a period in the modern day, at least that I’m aware of from a total return vantage point, that’s been so horrific and some of that’s due to corporate spread widening. And we have negative excess returns, but we’ve had certainly worse periods than this, but largely reflective of those back up in treasury yields. So, investor flows often follow returns and fund flows have been very negative this year. And that’s been a pretty consistent theme.
We saw a little bit of a blip where that changed in kind of late summer, but very negative flows. And the corporate market, it also benefited from inflows from non-US investors over the past number of years. So, non-US investors, large participants in the market represent roughly a quarter or so of the market. And the attractiveness on a currency hedge basis, it’s diminished for many non-US market participants, and that’s true for both European as well as Asia-based investors. So, that’s proven a serious demand headwind. But to bring this back around, the story’s much different for U.S. domiciled insurers and that very important offset is the all-in yield story, especially for those income-oriented or liability-driven investors, pensions, insurance companies.
Stewart: Yeah. And it seems like, and you mentioned 6%, that’s a number that I hear tossed around by a lot of folks on the buy side. It seems like a magic number to them like, “I can get 6% in IG fixed,” and it seems like that’s certainly been a number I’ve heard a few different times. So, with regard to the economy slowing and concerns of recession risk increasing, it’s certainly what you hear in the mainstream media, where do you think we are in the corporate credit cycle right now?
Matt: Sure. So, as I mentioned, this is something we’ve done a lot of analysis on at Conning, something we were talking about quite a bit. I think it helps to go back a few years and just give a broader perspective. Credit conditions, they deteriorated quickly as COVID-related shutdowns happened into the spring of 2020. And the cycle moves quickly, we call it the decline phase of the credit cycle, and that was just the uncertainty, the steep earnings declines. But just as quick the cycle turned favorable, the new issue market reopened, management teams focused on protecting credit profiles, re-liquefying and writing their balance sheets. So, the velocity of this credit cycle, it’s been unusually quick. So, our team believes now that we’ve moved into the latter stages of the cycle, and we refer to this at Conning as the reach phase of the cycle, and every industry within corporates that has its own nuances and is uniquely positioned in the cycle.
But if you think about the key external/internal determinants of this, the first of those would be just overall economic conditions and then the influence that those have on corporate earnings. So, the data is pretty clear that at a minimum we’re slowing, and you can see that in various economic measurements in the data at GDP, sentiment, housing, PMIs. But an important outlier here remains the very strong employment backdrop in the still relatively healthy consumer balance sheets. So, that’s the first part, and then the second part of that would just be corporate behavior and the allocation of capital. And if you think about investment grade corporate issuers, these tend to be larger companies, many of them are multinational in scope and they usually generate sufficient free cash flow to influence their credit profiles.
So, the allocation of that capital and understanding what management teams want to do with that is really key. And we’ve seen some very telling actions lately in support of balance sheets and credit profiles, perhaps just due to the more uncertain macro backdrop, which doesn’t seem to be changing any time soon. So, we’re going to be closely monitoring both the overall economy, management team behaviors to try and continue to decipher where the market’s heading, what areas offer better opportunity, as well as those that are presenting more risk, because eventually we are going to again start to move into that decline phase of the cycle.
Stewart: So, where does Conning think corporate earnings are in this cycle, given your outlook for recession scenario? And can you kind of throw profitability in there as well?
Matt: Sure. So, our base case at Conning is a mild recession, say over the next 12 months or so. So, that would be our base case. Corporate earnings in that scenario, we think they’re likely to weaken. And in addition to just those recessionary concerns, the aggressive rate increases by the Fed as well as other global central banks make that a likely scenario. The magnitude of weakening, it’s uncertain, but it does seem reasonable to assume that earnings estimates, they still have some potential downside associated with them. And it could potentially be material as well because there’s a lot of larger risks lurking out there. And if you just use the S&P 500 as a proxy for the corporate market, third quarter earnings, they held up perhaps better than what was feared, but there’s been a trend of deceleration and margin compression. So, that’s been evident.
And also, when you strip away the energy industry, which has had really robust results, it’s been a strong performer, certainly doesn’t look as good. So, we rely heavily on our analyst fundamental assessments and outlooks for industries under their coverage at Conning. And if you look at most of those fundamental outlooks for industries, most are stable right now. There’s been some recent shift to declining and that’s been in areas that I guess I would say they have some unique challenges, there’s some secular changes underway or some unique margin pressure that could be. I think of areas like chemicals, retailers, technology would all fit that bill that are fundamentally we view as declining right now. But all of that said, investment grade issuers are approaching this period of uncertainty from a position of strength.
So, credit metrics are back to pre-pandemic levels, corporate liquidity is good, and we believe that’s going to provide reasonable flexibility should we go into that potential downturn. So, one of the other things to think about is the credit cycle, it’s likely in its latter stages, but just this heavy amount of uncertainty around the economy, it might argue for more capital prudence and just lessen the desire of management teams to pursue re-leveraging activities.
Stewart: That makes sense. And I mean you had mentioned kind of larger issues and I kind of want to go there. The road ahead is certainly more uncertain than normal and there’s a host of things out there, global conflicts, Central Bank, China’s zero COVID policy. What do you think of those things are the most likely to significantly impact markets right now?
Matt: Yeah. I mean, you hit the nail on the head there. There’s lots of uncertainty out there and that’s contributed to huge swings in volatility this year. I would say certainly the Fed is heavy on the market’s mind, that looks set to likely continue for a bit here. But all of these areas of risk that you mentioned, it really needs to be reflected in higher risk premiums. And we’ve seen that investment grade corporate spreads, they’ve widened, I don’t know, call it 70% or so since year-end. So, our base cases is the volatility, these uncertainties, they’re likely to continue for a time. Some of these headwinds could be more secular in nature. So, an example, one of the outcomes of the geopolitical unrest and conflicts that could result in a trend towards de-globalization. There’s certainly been enough written about that and discussed about that recently. And that would be a big shift from the past number of decades.
And that could cause companies to rethink supply chains, reassuring a labor of factories probably contribute to more insular type of economies. And you think about what the implications of this would be for the market, it could ultimately prove more inflationary on the margin. So, these headwinds, they’re lurking out there. But I do want to mention, and I alluded to it before, but the strength of the consumer and labor markets, that is definitely an offset to this and to some of the concerns about the economy and unemployment is really low. There’s a huge amount of job openings. Call the consumer fully employed, consumers receiving paychecks. So, we’re hearing more and more about layoffs, but those have been more focused in the technology space right now and they haven’t been widespread. So, we likely need to see more weakness in the labor markets to encourage the Fed to start to take their foot off the pedal.
Stewart: Just kind of as we wrap here, I mean Conning is one of the leading managers of assets for insurance companies globally, right? It is your bread-and-butter business. You work with insurance companies of various kinds, various sizes, various types. When you take your outlook for the corporate market here and overlay that on an insurance portfolio, how are your strategists advising your clients right now of what they should be doing or how you’re positioning them in the corporate credit market?
Matt: So, there is a lot of uncertainty and risk in the marketplace, but there’s also a lot of opportunity. So, we want to focus in the investment grade corporate market on issuers that can weather a potential downturn. This is where our analysts, the focus on the fundamentals and the fundamental assessments that they’re valuable to identify issuers with durable credit fundamentals. And there’s also many areas that are less susceptible to an economic downturn. So, utilities, communication, those are more defensive and domestically oriented areas. Banking’s more exposed to the economy, but this is an interesting space because enhanced regulation is a strong benefit to help ensure adequate capitalization and benefit bond holders. Consumer non-cyclicals, a less economically sensitive area, but facing very unique margin pressures right now. So, that would be one area, just those durable credit fundamentals.
Then there’s also, if you think about the current geopolitical challenges, they’re presenting some interesting investment opportunities. The commodity in the energy markets, they’re benefiting from higher prices, and although pricing is off their highs, those prices do remain well above production costs and resulting in very strong cash generations. Our team believes balance sheets are in good shape, capital allocation policies remain prudent in that space.
Then there’s also some potential, and these are more tactical opportunities that are dependent on market volatility and tone. So, the new issue market would be one obvious place. It’s been active this year, but it’s been in fits and starts, so there is the ability for new issuance to continue to present selective opportunities where we could add to favored issuers when offering attractive new issue concession. Again, not all the time, but there are pockets of opportunity there.
And then there’s also potential opportunity to be found in the secondary market, and that would include less liquid off the run names where our team is really comfortable with underlying credit fundamentals and insurers obviously have the ability to be more buy-and-hold-oriented. So, those that can tolerate periods of spread volatility can really benefit in situations like this. And what’s really unique about the market right now, there’s plenty of shorter duration opportunities that offer compelling yields. And if one is more concerned about some of the macro turbulence, those shorter duration areas should prove a relative safe haven should something really go bump in the night.
Stewart: That’s fantastic. I really appreciate that. It sounds like very good advice. And just kind of as we wrap up, I just want to take you back to something you said earlier in the call. You had mentioned that when you were a painter in Malvern, Pennsylvania, that it was a hot job, and in the summer in particular, I’m sure it was unbelievable. And having the benefit of your career today and how things have worked out for you, if you would’ve come down off that ladder at the end of a long day, what would you tell your 21-year-old Matt Daly? What advice would you give yourself today?
Matt: Well, that’s an interesting question. I guess what jumps in my mind is keep working hard and show up, work hard, persevere. That would certainly be one thing. And the other thing is just in terms of learning, it’s a lifelong process and it’s not done. When I was painting, I was going to high school, then into college, but learning doesn’t conclude when school’s over, or for me as an example (you’ve completed your CFA designation), it’s continual, challenge yourself, read different things, talk to people that you might not necessarily agree with. And that seems like that might be a pretty good lesson right now for many of us in society, given the polarization that we’re going through right now as a country.
Stewart: Absolutely. And the nice thing is, Matt, for me, is the person on the other end of this podcast, I always learn a tremendous amount from our guests. And so, I want to thank you very much for being on today and giving me and our audience an education on investment grade corporate credit. So, thank you very much for being on Matt.
Matt: It was my pleasure.
Stewart: We’ve been joined today by Matt Daly, Head of Corporate and Municipal Teams at Conning. Thanks for listening. If you have ideas for podcasts, please email me at podcast@insuranceaum.com. My name’s Stewart Foley, and this is the InsuranceAUM.com podcast.
