Morningstar Magazine - June/July 2018 - 33

and the end of June 2006. The federal-funds rate
and Libor both rose sharply by more than
4 percentage points during that stretch, while
10-year Treasury yields spiked more than 100 basis
points. But, while the 10-year Treasury lost a tiny
bit over that stretch, the Eaton Vance and Fidelity
bank-loan funds each gained more than 4%.
There is a caveat, but one that applies to longer
time frames. In most cases, short-term rates
are driven up in response to healthy economic
conditions, which is usually good news for
bank-loan issuers. As long as their businesses
continue to thrive, the need to pay out larger sums
as their loan rates rise may not be a problem.
When economic weakness and high bank-loan
rates converge, though, the combination
can hurt the creditworthiness of borrowers and
threaten loan prices.
The story is a little different for TIPS. Although the
amount that the U.S. Treasury agrees to pay
a TIPS investor at maturity is periodically adjusted
in step with inflation, it usually moves in
small increments from year to year. TIPS yields
(and, thus, their prices) are generally very sensitive
to changes in those of comparable plain-vanilla
Treasuries, though, and the average maturity
of Vanguard Inflation-Protected Securities VIPSX
(and the Bloomberg Barclays TIPS benchmark) was
more than eight years at the end of March.
That's notable because bond investors can sometimes react forcefully to Fed actions. The
market has been progressively anticipating the
Fed's moves, and Treasury notes have reflected
it. The 10-year Treasury yield began a rising
cycle around the end of 2017, moving up roughly
60 basis points through April 27 and taking
a 1.3% bite out of Vanguard Inflation-Protected
Securities during that stretch.
Fortunately, there isn't any broad expectation that
longer-term Treasury yields are set to go up
exceedingly fast or all that much more as a result
of inflation or the Fed's next hikes. In fact,
despite occasional pundit worry that long yields
are on the brink of soaring, market prices
in late April implied that 10-year Treasury yields
would be only 0.1% to 0.15% higher five years
hence. Of course, market expectations are just

that, and TIPS can certainly be even more
volatile from month to month, so it's still worth
making sure that you can stomach the pain if the
market reacts differently.
Eric Jacobson is a senior analyst, fixed-income strategies,
with Morningstar Research Services.

Card Issuers Start
to See Credit Quality
Diverge
First-quarter results represent a divergence among
credit card issuers. All credit card issuers
are at different stages of growth in this credit cycle
and displaying mixed performance. On the basis
of card issuer performance this quarter, Capital
One Financial COF appears to be one step
ahead of peers, while Synchrony Financial SYF and
Alliance Data Systems ADS are still digesting
recent elevated growth and American Express AXP
is trying to catch up.
We think Capital One is really realizing and expanding on the benefits of its HSBC card acquisition six
years ago. We believe the greatest rewards
go to the companies first to push the accelerator
early in a credit cycle, when competition is
low, and the first to hit the brakes toward the end
of the cycle, when competition is high. On this
front, Capital One stands out.
For credit cards, the best leading indicator of credit
performance is a company's delinquency rate,
as one quarter's delinquencies are highly
correlated to credit losses in the following quarter.
While the market is focused on a potential
turn in the cycle, Capital One's card delinquencies
actually fell from the first quarter of 2017,
and American Express' delinquency rate was flat.
Alliance Data Systems' delinquencies were
up 50 basis points year over year, which comes on
top of March 2017's increase of 50 basis points.
The company attributes much of the increase
to hurricane activity. However, neither Capital
One nor Synchrony saw a similar rise in
delinquencies, and neither mentioned hurricanes
affecting payment behavior during the quarter.

Capital One's portfolio is also less exposed
to retailer bankruptcies than private-label issuers
Alliance Data Systems and Synchrony-
its recent growth has been more weighted toward
its general-purpose and rewards cards. We
anticipate Synchrony will follow Capital One and
soon see fewer delinquencies and lower credit
losses. At the end of the first quarter, Synchrony's
delinquency rate stood at 4.5%, a 20-basis-point
increase from the previous year. Though its
acquisition of the PayPal portfolio could affect this,
Synchrony appears to have slowed growth well
ahead of the turn in the cycle.
Alliance Data Systems is the most exposed to
beleaguered mall retailers, which is the major
reason we reduced our 2018 and 2019 loan growth
forecast to 12% and 5%, respectively, from
14% and 10%. We also see Alliance Data Systems
as the most aggressive issuer. Though some of
the company's growth has been through portfolio
acquisitions, the company has no plans to
slow loan growth, forecasting portfolio growth in
the midteens in 2018. In comparison, Capital
One and Synchrony increased card portfolios by
8% and 6.2% in the first quarter. We're also
somewhat cautious on American Express' relatively
late-cycle growth. Though the company targets
a different customer segment, its heady firstquarter growth rate and past missteps in lending
warrant close scrutiny in quarters to come.
We like that card issuers have been returning
capital. Synchrony has the lowest leverage,
with assets that are 6.7 times equity, and is well
positioned to create value through share
repurchases and modest increases in leverage.
Capital One has modestly higher leverage
at 7.3 times, and Alliance Data Systems has
consolidated assets of 14.7 times equity. American
Express' capital ratios were hit by the late 2017
change in corporate tax rates, and the company
has temporarily halted repurchases. That
said, aggressive capital returns contributed to a
38% year-over-year increase in earnings per
share in the first quarter.
Colin Plunkett CFA, is an equity analyst with Morningstar
Research Services.

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018