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Strengthened Credit Profiles in Basic Materials Sector

Sean Sexton, CFA

Seth Sexton: Credit fundamentals in the basic materials sector have improved further over the course of this year as prices for many commodities continued their rise which began in the first half of 2016. This, coupled with efforts issuers made to deliver over the past 24 months, has strengthened credit profiles in the sector.

The improvement in credit fundamentals can be illustrated by the narrowing in credit spreads in the sector that has occurred over the last couple of years. The top line of this graph is the spread in basis points over U.S. treasuries for the sector. The basic materials index's credit spread rose to a recent peak of 436 basis points in February of 2016. This spread narrowed to 312 basis points a year ago and is currently at 131 basis points demonstrating market perception of the improvement in credit fundamentals.

In the metals and mining part of the sector, many issuers took aggressive steps to reduce debt balances that included asset sales and equity issuances. The debt reduction along with better prices for mined commodities and margins for metals has resulted in issuers being upgraded or possessing positive outlooks.

The chemicals portion of the sector remains stable as result of consistent demand and pricing. We expect continued stability unless a recession occurs. We also see the potential for M&A due to the consistent free cash flow profiles of many chemical issuers and the still low interest rates available to many corporate borrowers.

The ag part of the sector has been in the midst of a consolidation phase largely due to a weakening of fundamentals in the farm sector over the past few years. Still the outlook is stable despite the weakness due to the conservative capital structures of issuers in this space.

Finally, building materials issuers currently enjoy strong demand fundamentals. We anticipate increased spending on infrastructure in the U.S. will support further growth for these issuers.

In summary, we expect credit fundamentals in the basic materials sector to remain solid near term given expectations of price strength of products sold in the sector. That said, a downturn will inevitably come, but fixed-income investors can take comfort in the fact that capital structures in the sector now are considerably stronger than they were 12 to 24 months ago.