Democracy is the theory that the common people know what they want, and deserve to get it good and hard. - H.L. Mencken (source: BrainyQuote)
"This is not a leveraging exercise; it is really about bringing the product to the marketplace" - Margaret Lui, CEO of Azalea, a subsidiary of Singapore-based Temasek Holdings, on the launch of the world's first listed private equity bond for retail investors. (credit to Grant's Interest Rate Observer)
The end of market cycles typically begins with some choice anecdotes capturing the spirit of market excess that aggregate market metrics will initially miss. Eventually, enough of these 'anecdotes' accumulate raising the attention of major market observers (i.e. your bulge bracket economist or strategist). Some of them will casually dismiss the anecdotes as just that… anecdotes; others will 'monitor' them for signs of further excess.
But as the old Wall Street adage goes, 'no one rings a bell at the top (or bottom) of the market. At the very least, the nationally-recognized statistical rating organizations (NRSRO) such as S&P, Moody's, and Fitch, did not ring the 'top-of-the-credit-market' bell for the last three credit cycles (as far as our memory goes… please contact us if we're incorrect).
Since investors mainly work in the realm of probabilities, each one possesses his/her own threshold for the accumulation of evidence that triggers an internal bell-ringing moment. For some, the accumulation of evidence starts with the participation of the retail investor. The second quote above comes from Azalea CEO Margaret Lui who is excited about the prospect of making available risky private equity debt to the retail marketplace. For $2,000, you can participate in the type of credit normally afforded to sophisticated, institutional investors. Rejoice indeed.
It would seem that the credit sell-off that followed the commodity price sell-off in 2014-2015 is but a passing memory for many fixed income investors drawn to the siren song of extracting yields from risky borrowers priced at narrow spreads above U.S. Treasuries. Borrowing from H.L. Mencken, the retail audience eventually gets what they're clamoring for… and may get more than what they want.
First, the Good News…
The good news for U.S. high yield investors is that overall credit metrics still look benign, even for the most levered cohort of borrowers. "As the credit cycle enters its late stage, key metrics are stronger than before the start of prior recessions, pointing towards lower expected default rates in the near term," according to Fitch Ratings (dated 6/4/2018). And this assumes we are in the late stages of the credit cycle - a majority of economists are forecasting a recession in the 2020-2021 time frame, but when have economists, as a group, ever correctly forecasted a recession?
For instance, the distress ratio (defined as the number of distressed credits as a percent of the speculative-grade market) for high yield borrowers stands at 4% versus 10% in late 1999 and late 2007, both late cycle years that preceded the last two recessions. Fitch goes on to observe that "this credit cycle is reminiscent of 2006-2007, with a strong economy, open leveraged finance markets and a low default environment." Fitch is forecasting a 2% default rate for high yield borrowers in 2018.
Figures 1a and 1b displays the overall credit metrics across ratings bands, namely median financial leverage (debt/earnings before interest, taxes, depreciation/amortization or EBITDA) and profitability (EBITDA margins). The last two years have witnessed elevated financial leverage, but that is partly supported by improved profitability from the depths of the 2014-2015 credit sell-off.
Figures 1a and 1b - Overall Credit Metrics (Debt/EBITDA and EBITDA Profitability) Across Ratings Bands Have Not Moved Much Over the Past Two Years
In addition, S&P Global Market Intelligence notes that leveraged loan borrowers have experienced a surge in EBITDA growth, partly as a result of tax reform legislation passed in late 2017 but also due to improvement in core operations.
Investors recognize that the current macro environment is still supportive of taking on credit risk, but to focus this risk-taking on the short-end of the yield curve as the Federal Reserve maintains its rate tightening schedule. According to Fitch, "the U.S. institutional leveraged loan market has narrowly surpassed that of high yield bonds for the first time since 2008" and that the size of the leveraged loan market has reached $1.22 trillion at the end of May 2018, with technology companies comprising much of the recent new issuance. Fitch estimates that $17 billion has flowed into bank loan mutual funds since the start of 2017. Since the start of 2018, Bloomberg estimates $1.57 billion net inflows into bank loan exchange-traded funds (ETFs) in contrast to $5.91 billion net outflows from traditional high yield ETFs since the beginning of 2018 (source: Bloomberg ETF Flows).
In other words, there is still plenty of runway left for this high yield cycle to travel on assuming that the current business cycle continues.
Widening Credit Spreads - A Sign of Increased Stress or a Sign of Increased Issuance from Marginal Creditworthy Borrowers?
Yet, a longer runway for borrowing creates its own set of risks. For instance, a greater appetite for credit risk can invite a greater number of marginal creditworthy borrowers (or a willingness to take on more debt as a percentage of total capital) to meet that risk appetite. As a result, the asset class becomes inherently riskier due to the increased presence of less creditworthy borrowers and/or highly levered debt issuance as a percentage of total capital.
S&P Global Market Intelligence partly confirms this as they observe that the recent widening of high yield loan spreads (Figure 2) can be attributed more to the mix of new issuance (namely from more levered and/or less creditworthy borrowers) versus investors pricing in a more adverse credit environment. Speculative-grade borrowers have been operating in a nirvana of low interest rates (by historical standards) and 'take my money' attitude among yield-starved lenders/investors. As a result, the high yield loan asset class is being repriced (in the form of higher spreads) to account for the increased presence of marginal creditworthy borrowers.
Figure 2 - "Leveraged Loans: LIBOR Spread for Riskiest US Borrowers Hits YTD Highs"
And lenders are demanding less protection in the form of covenant-lite loans (Figure 3) that provide financial safeguards to better protect the interests of borrowers versus equity holders. One counterargument we've heard from a buyside high yield firm is that covenants can perversely restrict company management's ability to strategize and work out tough situations by reducing their capital flexibility. However, covenants serve as a check against management's propensity to throw Buster Douglas-style haymakers (see the 1990 fight vs Evander Holyfield) when trying to turn the company ship around.
Figure 3 - 'Take My Money!' Covenant-Lite Loans Now Comprise 77% of U.S. Leveraged Loan Market
Yet the window for low cost borrowing on easy credit terms may be closing as the Federal Reserve remains committed to its rate hike schedule (Fed Funds futures are pricing in 2.25-2.50% Fed Funds rate by year-end up from the 1.50-1.75% range prior to the June meeting). So, a shortening of the credit cycle runway may begin with tighter financial conditions driven by the Fed, which will drive up borrowing costs. The issue then becomes which speculative grade borrowers can weather the higher borrowing costs assuming a benign macro environment (throw in a business cycle downturn, and all bets are off).
So, whether due to higher interest rates creating tighter financial conditions, a slowdown in the global macro environment, or increased issuance from marginal creditworthy borrowers, one shouldn't be surprised that credits have widened, especially at the lower end of investment grade (Figure 4), although these spreads remain narrow versus historical levels. But credit risk is ultimately exponential in nature as highly levered borrowers may be able to absorb one hit but not several all at once.
Figure 4 - Rising Credit Costs for Lower Investment Grade and Speculative Grade Borrowers (Through 6/12/2018)
High Yield is Equity 'Wolf' Risk in Fixed Income 'Sheep' Clothing
As long as equity markets continue to perform well, high yield can perform well. Many fixed income managers like to invest in high yield due to its low correlation with the broader fixed income market, but this is primarily due to high yield's higher correlation with equity market risk (Figure 5).
Figure 5 - Post the 2008 Financial Crisis, High Yield Has Correlated More with Equities than Fixed Income
The challenge with high yield investing is that the investor takes on equity-type risk but with the upside limited by the coupon. As we originally wrote in "Time to Buy High Yield (If You're Tactical and Have an Iron Stomach)" back in February 2016 (our one bell-ringing moment):
"High yield bonds share much of the market risk inherent in equities as high yield borrowing largely serves to fund future growth initiatives (or fund large dividend payouts for private equity investors). Unfortunately, high yield investors do not share in the upside if these growth projects bear fruit but share most of the downside should they don't. That asymmetric risk profile should be reflected in the underlying yield offered to investors. When spreads are narrow, investors are hardly compensated for taking on this risk. When spreads are wide, high yield bonds reflect more of an out-of-the money call option on future prospects. It's an area that investors should tread carefully."
With narrow spreads and a debt market increasingly dominated by highly levered/lesser creditworthy borrowers and covenant-lite issuance, fixed income investors should, indeed, tread more carefully, regardless of the global growth environment. Whether it's traditional high yield or emerging market debt, if investors want to take on 'equity' risk, they should consider taking it in their equity portfolios rather than fixed income.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of June 13, 2018, and are subject to change as influencing factors change.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.