by Pater Tenebrarum, Acting Man:
Credit Market Bifurcation
By all accounts, credit markets remain on fire. 2019 is already a record year for corporate bond issuance, beating the previous record set in 2017 by a sizable margin. Demand for the debt of governments and government-related issuers remains extremely strong as well, despite non-existent and often even negative issuance yields. Even now, with economic activity clearly slowing and numerous threats to the post-GFC recovery looming on the horizon, the occasional rise in credit spreads is routinely reversed. And yet, under the placid surface problems are beginning to percolate. Consider exhibit A:
The chart shows option-adjusted credit spreads on three rating categories – while spreads on ‘BB’ rated (best junk bond grade) and ‘BBB’ rated (weakest investment grade) bonds remain close to their lows, spreads on ‘CCC’ rated bonds continue to break higher – considerably so. An increase by 473 basis points from their late 2018 low indicates there is quite a bit of concern.
It is actually rare for credit spreads on these rating classes to drift apart to such a significant extent at a time when spreads on better-rated bonds are still close to their lows. Normally the exact opposite happens – when spreads are tightening, they also tend to tighten between the different rating classes – only when spreads are widening across the board will spreads on lower rated bonds display a tendency to widen to more rapidly than those on better-rated ones.
This bifurcation is actually a subtle warning indicating that the credit cycle may finally be coming to its end. It is “subtle” in the sense that it is generally not yet perceived as a sign that trouble is brewing – rather, it is dismissed as a sign that bond buyers have become slightly more selective (a good thing). In view of a record year for corporate bond issuance it is probably not surprising that concern remains muted.
To be sure, high yield defaults remain very low – and while they are forecast to increase, a major surge in defaults is currently not expected. However, these superficially placid conditions are masking growing turmoil – as so often, the devil is in the details. Consider the following data point released by S&P in mid October:
Weakest links are defined as issuers rated ‘B–’ or lower by S&P Global Ratings with negative outlooks or ratings on credit watch with negative implications. As S&P helpfully explains:
“The default rate of weakest links is nearly eight times greater than that of the broader speculative-grade segment, and the rise in the weakest links tally may signify higher default rates ahead.”
Readers may be surprised to learn that contrary to 2015-2016, oil and gas companies are not leading the pack – consumer products companies are (52 issuers or ~20%). Energy companies are in second place, representing around 10% of the total, followed closely by media companies and restaurant chains.
All of these sectors are held to be under pressure due to industry-specific problems, but that doesn’t change the fact that a great many companies have obviously over-leveraged their balance sheets. The growth in “weakest links” in the strongest developed economy is testament to the proliferation of zombies central bank policies have created in recent years.
S&P nevertheless expects the US junk bond default rate to reach a mere 3.4% over the coming year, which is actually still a fairly benign number. Presumably this is not factoring in the possibility of a recession. It seems to us there is a substantial risk that this forecast will be subject to upward revisions as time goes on.
Leveraged Loans, Private Equity and Banks
In recent years enormous amounts have poured into private equity and venture capital funds. Not surprisingly, the rising popularity of unlisted alternative investments (read: illiquid investments) has made it more difficult for them to deliver the large returns that initially attracted investors. Leveraged loans play an important role in private equity buyouts – but recently the situation in leveraged loan land has deteriorated noticeably. Here is a brief summary from Almost Daily Grant’s, a publication of Grant’s Interest Rate Observer:
“Signs of trouble abound. According to S&P’s LCD unit, 282 issuers within the S&P/LSTA Index suffered a rating downgrade in the year-to-date through Oct. 11, up from 244 for all of last year and just 33 in 2017. That has pushed the proportion of leveraged loans rated triple-C (“In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitments on the obligation.”) to 7.5% of loans outstanding at the end of September, according to S&P. That’s the highest level since 2013 and up from 6.3% in June. Needless to say, the increasing prominence of private equity in tandem with a cyclical credit deterioration presents a delicate backdrop.”
The ratio of loan downgrades to upgrades has soared
The growth in private equity (PE) AUM has increased buyouts of listed companies and pushed up the prices at which they are done (the result of too much money chasing deals), but now the strategy is running into a problem: monetizing these investments has become increasingly difficult. Fewer and fewer deals are making it to the IPO stage, which is – apart from saddling the targets with debt so they can make large dividend payments – the main goal of PE investments.
The percentage of distressed leveraged loans is on a strong upswing as well – note that the high levels in 2016 coincided with a raft of bankruptcies in the energy sector in the wake of the 2014-2016 oil price collapse.
As noted above, leveraged loans have become a favored form of debt in PE buyouts, and lately a number of deals either did not get done at all, or only after major concessions were made. This makes it more difficult to bear the debt and lowers the prospective returns of PE investments. Grant’s again: