I have just stepped out of our annual flagship conference in London, Solving for 2020, where I debated this year’s outlook for credit markets with my colleague David Lyon, who co-heads our Private Credit business.
Given the complexity that investment views tend to accrue as we get late into the cycle, especially in a market such as credit that has changed so much over the past decade, we decided to make things simple. I would make an unapologetic bull case, and David would play the bear.
Slow but Positive
I made the same case that we in the Fixed Income team would have made 12 months ago, or even 24 months ago.
Slow-but-positive global GDP growth can cover up a lot of debt issuers’ problems for a long time. There will be isolated challenges and defaults—we are certainly cautious about lower-rated energy and the auto sector—but widespread sell-offs in credit tend to be grounded either in systemic financial problems or in debt-funded mal-investment.
Neither is evident today. Financial-sector leverage remains relatively low. And corporate investment in capital-intensive things like factories and autos is also low relative to investment in technology, which is much more likely to be internally financed.
That’s partly a result of corporate managements recognizing that this cycle is growing old. As such, we have already seen corporate leverage peak and begin to decrease. That’s true even in places like BBB rated investment grade, where issuance has ballooned over recent years: After hitting 3.9 to 4.2 times EBITDA, it is now down to 3.5 to 3.7 times, according to JPMorgan.
Moreover, because interest rates have been so low for so long, that leverage comes with much better interest-coverage ratios and longer maturities than it typically would have in the past.
Lower Recovery Rates
David zeroed in on leveraged loans for his bearish case.
He observed that the credit quality of the S&P/LSTA U.S. Leveraged Loan 100 Index has deteriorated: B rated, mainly private-equity sponsored issuers have gone from 37% of that index two years ago to 50% today. According to our estimates, those issuers are nominally leveraged at 6.5 times EBITDA but, as David argued, once you strip out all of the questionable adjustments made to reported earnings, that looks more like 13 times. And for underwriting that, you get less than a 6% yield.
He wasn’t finished there. He highlighted the growth in the size of the loan market, as well as the growth of collateralized loan obligations (CLOs) as buyers of loans, and the weakening of covenant standards.
That, together with asset-price inflation in a low-rate environment, is likely to lower recovery rates. We are already seeing that, but the default rate is still at a modest 2% per year. David warned that portfolio risk models, calibrated for high-yield recoveries of 40 cents on the dollar and loan recoveries of 60 cents, may not prepare investors for a scenario in which defaults are rising and recovery rates are more like 25 cents and 45 cents.
Bearish Bulls and Bullish Bears
In the end, David and I agreed more than we disagreed. And I also acknowledged his argument that this is not just about the loan markets. The current extreme bifurcation of credit markets means that, sure, there are high-quality issuers out there—but they trade at very tight spreads partly because of credit deterioration elsewhere.
But what might be the catalyst for a turn in our stable growth and interest rate environment? Nothing clear and obvious stands out. When we have seen these discrepancies between asset valuations and the economy in the past, the environment has often supported asset prices for longer than expected.
David, who spends a lot of his time seeking distressed opportunities, knows this dynamic as well as anyone. While he made the bearish case with total conviction and impressive evidence, he conceded that one cannot invest bearishly until one is sure that appetite for risk is about to dry up.
And so, we agreed on a view that reflects our most recent Fixed Income Investment Outlook: We do not see any obvious threats to a stable environment in 2020, but we do see potentially serious issues in some parts of the credit markets—issues that may cause volatility before the year is out.
When we polled our audience, they appeared to be on the same page. Most anticipated positive total returns in U.S. high yield this year. But they also picked out leveraged loans, CLOs and CCC bonds as their main causes for concern, in line with a more cautious outlook for risk and an up-in-quality bias in the credit market.
You really cannot oversimplify things in late-cycle credit investing, it seems. It turns out to be a world of bearish bulls and bullish bears.
In Case You Missed It
- Bank of Japan Policy Rate Decision: The BoJ made no changes to its policy stance
- U.S. Existing Home Sales: +3.6% to SAAR of 5.54 million units in December
- European Central Bank Policy Meeting: The Governing Council made no changes to its policy stance
- Japan Purchasing Managers’ Index: +0.9 to 49.3 in January
- Japan Consumer Price Index: +0.7% year-over-year in December
- Euro Zone Purchasing Managers’ Index: +1.5 to 47.8 in January
What to Watch For
- Monday, January 27:
- U.S. New Home Sales
- Tuesday, January 28:
- U.S. Durable Goods Orders
- S&P Case-Shiller Home Price
- U.S. Consumer Confidence
- Wednesday, January 29:
- FOMC Meeting
- Thursday, January 30:
- U.S. 4Q 2019 GDP (First Estimate)
- China Purchasing Managers’ Index
- Friday, January 31:
- Euro Zone 4Q 2019 GDP (Preliminary)
- Euro Zone Consumer Price Index
- U.S. Personal Savings and Outlays
Statistics on the Current State of the Market – as of January 24, 2020
|S&P 500 Index||-1.0%||2.1%||2.1%|
|Russell 1000 Index||-1.0%||2.2%||2.2%|
|Russell 1000 Growth Index||-0.7%||4.1%||4.1%|
|Russell 1000 Value Index||-1.2%||0.2%||0.2%|
|Russell 2000 Index||-2.2%||-0.3%||-0.3%|
|MSCI World Index||-0.8%||1.6%||1.6%|
|MSCI EAFE Index||-0.6%||0.4%||0.4%|
|MSCI Emerging Markets Index||-2.4%||0.5%||0.5%|
|STOXX Europe 600||-0.8%||0.1%||0.1%|
|FTSE 100 Index||-1.2%||0.6%||0.6%|
|CSI 300 Index||-3.6%||-2.3%||-2.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.2%||0.2%||0.2%|
|Citigroup 10-Year Treasury Index||1.4%||2.2%||2.2%|
|Bloomberg Barclays Municipal Bond Index||0.4%||1.4%||1.4%|
|Bloomberg Barclays US Aggregate Bond Index||0.8%||1.3%||1.3%|
|Bloomberg Barclays Global Aggregate Index||0.6%||0.4%||0.4%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.1%||0.5%||0.5%|
|ICE BofAML U.S. High Yield Index||-0.4%||0.3%||0.3%|
|ICE BofAML Global High Yield Index||-0.3%||0.3%||0.3%|
|JP Morgan EMBI Global Diversified Index||0.0%||0.9%||0.9%|
|JP Morgan GBI-EM Global Diversified Index||0.1%||-0.1%||-0.1%|
|U.S. Dollar per British Pounds||0.3%||-1.4%||-1.4%|
|U.S. Dollar per Euro||-0.6%||-1.8%||-1.8%|
|U.S. Dollar per Japanese Yen||0.7%||-0.7%||-0.7%|
|Real & Alternative Assets|
|Alerian MLP Index||-5.7%||-2.1%||-2.1%|
|FTSE EPRA/NAREIT North America Index||0.7%||2.9%||2.9%|
|FTSE EPRA/NAREIT Global Index||-0.2%||1.4%||1.4%|
|Bloomberg Commodity Index||-3.1%||-4.3%||-4.3%|
|Gold (NYM $/ozt) Continuous Future||0.7%||3.2%||3.2%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||-7.5%||-11.3%||-11.3%|
Source: FactSet, Neuberger Berman.