For once, credit investors can thank the spectre of rising interest rates for strong returns, says Jon Brager, senior analyst at Hermes Credit..
Welcome relief: Ford and General Motors (GM), with their chronically under-funded pension schemes, were poster children for perceived US industrial decay at the depths of the financial crisis. But higher US Treasury Bond yields have since elevated the metric used to gauge future liabilities: larger “discount rates” have shrunk pension obligations. For credit investors, this boosts the credit quality of parent companies by driving down balance-sheet gearing and improving free cash flow.
Big picture: In 2013, companies in the S&P500 index saw their defined-benefit pension deficits contract 35% to $432bn. Since unfunded liabilities can be seen as interest-bearing debt, this is the equivalent of $248bn in corporate deleveraging and promotes balance-sheet strength and boosts free cash flow as companies don’t need to contribute to schemes. For example, GM and Ford paid $1.5bn and $5.4bn to their respective pension plans in 2013 but, as a result of a stronger funded status, both companies do not expect to make any further commitments in 2014 or 2015.
High-yield highs: The performance of five-year credit default swaps (CDSs) for automotive, manufacturing, transport and mining businesses show the implications of shrinking pension deficits for credit investors. The four high-yield debt issuers that experienced the greatest falls in pension liabilities, which includes GM, benefited from greater spread compression than the market. This outperformance started, in fact, when the US Federal Reserve triggered a spike in yields and subsequent sell off in June 2013 by foreshadowing tapering.
Credit default swaps on US industrials have performed well since the 2013 high-yield market sell off
Pole position: Investment-grade issuers with large, under-funded pensions have also outperformed. This includes Ford, which experienced the greatest deficit improvement among all US industrials. Its liabilities fell $10.7bn, helping to cut its net leverage – which includes pension obligations – by more than two-thirds to 0.39x. It seems no coincidence that the Ford five-year CDS has performed strongly since its improved pension status was first announced in its financial-year 2013 results.
Investment-grade issuers have also benefited from shrunken deficits in their corporate pensions
Not over yet: Credit securities from many other US industrials should continue to benefit as balance-sheet improvements and increased free cash flow tighten spreads. The outperformance of high-yield and investment-grade issuers amid fears of rising interest rates is promising: in a market heavily influenced by policymakers, company-specific fundamentals can still determine valuations and yield rewards.
The views and opinions contained herein are those of Hermes Credit, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Funds Managers does not warrant its completeness or accuracy.
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