Authored by Vishwanath Tirupattur, Morgan Stanley’s head of Fixed Income Research
As the Cycle Turns…
It is that time of the year again – time to review how the year has been and for strategists like us to return to the occupational hazard of crystal ball-gazing about the prospects for next year. Corporate credit markets, particularly in the US, are heading to a notably negative return year. Notable because it is a dramatic reversal of fortunes from a year ago and coming in a year of strong growth in the US economy, with defaults and ratings downgrades at rather benign levels. It is worth noting that this reversal of fortunes is precisely what our US credit strategists had predicted for this year. They now expect this bearish turn to continue in 2019.
The tricky handoff from quantitative easing (QE) to quantitative tightening (QT) that is under way is central to the cracks that have appeared across risk markets and credit markets in particular. Global QE provided the necessary conditions for corporations to lever up, which is exactly how they responded.
Outstanding US corporate credit market debt has more than doubled from US$3.2 trillion in 2008 to well over US$7 trillion today, with the biggest chunk of it coming in the BBB portion of the credit curve, the lowest rung of investment grade ratings. High debt growth has translated to high leverage – BBBs with 31% of BBB debt leveraged at or above 4.0x.
Lower yields driven by QE had important consequences for investor behaviour as well. The search for yield became a driving force which led to substantial inflows into US credit, particularly overseas investors. Also thanks to the Fed emerging as a large non-price-sensitive, programmatic investor of agency mortgage-backed securities (MBS) as part of QE, fixed income investors became progressively underweight MBS and overweight corporate credit. As the cycle got extended, the net result of these flows into credit investments has seen the manifestation of late-cycle excesses in credit markets. High debt growth has led to high leverage and weak structural protections for credit investors.
With the transition into QT, these flows are reversing. We have a marked drop-off in 2018 of foreign investor flows into US credit investments.
Without the Fed to compete with, fixed income investors are looking to rebalance their portfolios with an eye on agency MBS, where spreads are at post-crisis wides. At the same time, the effect of the latecycle excesses that built up during QE are beginning to come to a head in corporate credit fundamentals. As growth decelerates and company earnings’ growth slows, these fundamental cracks are set to widen. As Adam Richmond, the head of US credit strategy, noted in a recent note, as the credit cycle turns, there is a potential for meaningful fallen angels, bonds downgraded from investment grade to high yield. Given how big the credit market, particularly the BBB segment, has become, downgrades into high yield will likely emerge as a major ‘stress point’ in the next credit cycle.
Another focal point of late-cycle excess has been in leveraged loans, which are now larger than the high yield bond market. Loan leverage levels have risen consistently in this cycle, especially first lien leverage, and those leverage levels have become more ‘optimistic’ with larger and larger EBITDA adjustments. The debt cushion beneath the average loan has gotten smaller all cycle, which should translate directly into higher loan losses in the event of default, with an increasing prevalence of loan-only deals. The growth in structured products such as collateralized loan obligations (CLOs) has driven the growth in leveraged loans. If the pace of new issuance slows in CLOs as we expect over 2019, the leveraged loan market would face additional headwinds.
As the credit cycle turns, an important distinction needs to made about how this credit cycle turn would evolve compared to past cycles. We would argue that this credit cycle turn would be much like the ones we saw during the early 1990s and late 1990s – a gradual pick-up in defaults and downgrades over multiple years – and unlike what we experienced during the last cycle turn during the financial crisis of 2008-09, when there was a spike up in defaults and downgrades which was followed by a spike down to historical average levels in a relatively short period of time.
The consequence of this shape of evolution of the credit cycle is that the large systemic dimension of the last crisis would be much less pronounced and what we will realise is a more garden-variety credit cycle turn, something credit investors have more experience in dealing with. That said, no doubt a cycle turn is coming, and this bearish turn will be painful for credit investors, in our view.
The silver lining is that investor complacency is lower and valuations have gotten cheaper in the last few months. Even if the consensus has embraced the idea that end-of-cycle risks are rising notably, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. That said, the credit bear market has started, and until valuations have truly priced in long-term fundamental risks, our advice is that investors should use rallies to move up-in-quality. Have a great Sunday.
via RSS https://ift.tt/2GkF8Cf Tyler Durden