BofAML's Mike Cantopoulos' distaste for corporate fundamentals, displeasure with the efficacy of QE and easy monetary policy on spurring growth and inflation, and concerns that a further deterioration in credit conditions will create deeper economic troubles not appreciated by many have left credit markets with poor default adjusted valuations and little room to absorb a negative shock. He highlights nine key reasons below why BofAML believes this rally won't last (and in fact may have already seen its end).
As BofAML explains, we continue to hold this bearish view in the face of a market rally that has wiped out all the widening from December through February 11th. In fact, one could go so far as to say we are not only just as bearish as ever, but perhaps more so, as earnings disappoint and economic weakness appears to be broader based than we have seen since the recession, yet the Fed, in all likelihood, will likely be compelled to hike rates despite these problems. To these points, below we highlight the 9 key reasons we believe the rally won’t last (or may have already seen its end).
9 reasons the rally won’t last (or may have seen its end)
1. Default adjusted valuations are the worst since the crisis
First and foremost, current high yield valuations are simply irrational if we’re correct and 2015/2016 marks the end of the high yield credit cycle. Consider that on October 19th, 2015 we wrote high yield was not compensating investor’s for default risk if one were to assume a 5 year cumulative default rate of 33% with a recovery of 35%. The annualized return under this scenario worked out to 1.4%. On February 11th, 2016, we reran our analysis and the market under such assumptions implied an annualized return of 3.54%. Even under a more severe default wave, where default rates approach 38% and recoveries 30%, February 11th valuations still guaranteed a 2.28% annualized return. However, after the recent rally, the US high yield market barely compensates investors for risk over a 5-year horizon. Under our more benign scenario, annual returns are just 1.23% and assuming a higher default rate and lower recovery (a scenario we don’t only view as possible, but probable), valuations today guarantee just a 0.41% return. In other words, when adjusting for default risk, US investors are earning 80bp less than 5y treasuries under our probable scenario and on par with our benign default scenario.
To the above point, what good is a high coupon or yield if enough price loss and defaults occur to wipe out any cash inflow? Another way to think about spread compensation for default risk is to calculate the spread over the next 12 months of credit losses. Assuming a next 12 month default rate of 7% and recovery rate of 25%—very realistic estimates, in our opinion—current spread levels are just 103bps above next 12 month credit losses. Even worse, at these levels investors experience negative excess returns over the next 12 months 93% of the time, with an average next 12 month return of -8% (Chart 1). If history is a good barometer of future expectations, at current levels, investors would be far better off investing in Treasuries or other government securities or high grade despite the marginally lower yields the asset classes have to offer.
2. Priced for perfection: No room for a surprise
With current yields not compensating investors for default risk, we believe the asset class is not only priced for perfection, but has very little room to absorb any shock. We wrote last week that the market misinterpreted the FOMC statement, and that the Fed, by subtly sounding less dovish, was beginning the process of preparing the market for a June or July rate hike. Though we think the signs from the corporate market are clearly suggestive of a weak economy and Q1 GDP at just 0.5% (with broad based weakness that extended from manufacturing to trade to the consumer) would indicate that the central bank should remain accommodative, we think the Fed is currently faced with the rare dilemma of how to deal with slow growth in the face of strong employment.
There are really only two explanations for such a phenomenon. Either there is still slack in the labor force, and growth is not near potential, thereby implying the need for further accommodative action, or the labor market is tight, but less productive, and as a consequence the economy is much closer to potential than perhaps the Fed would like to admit. We have subscribed to the latter theory, and it seems to us that the FOMC is perhaps beginning to move towards that camp as well, and is all the more likely after today’s ADP employment report and productivity data (Chart 2 and Chart 3).
If we are correct, this confluence of factors means the FOMC will put more weight on the unemployment figures under the assumption that inflation will pick up in the future than on growth, which though low, may be near or even at potential. On the other hand, risk markets (high yield and equities) seem to be taking for granted that central banks will remain accommodative in the face of low growth, perhaps not believing that the Fed has the nerve to hike in the face of easing central banks globally.
And if the market’s initial reaction to the FOMC statement last week and this week’s reaction to William’s and Lockhart’s comments (where they both noted June as a live meeting) are any indication of how high yield will react to a Fed that is determined to diverge from the rest of the global central banks, markets are likely to fall (Chart 4).
Conversely, if the Fed stays on hold in June and July, it is likely not economic factors that cause them to do so but rather market-based factors. We saw earlier in the year that Chair Yellen is highly sensitive to the volatility in global markets, and should credit widen and equities fall significantly, we think her decision becomes much more difficult. In either case, high yield suffers, either at the hands of the Fed or in spite of it.
3. Dollar is a double edged sword
With a Fed that is likely to hike if markets cooperate, or not hike if they don’t, we consider the influence the dollar will have on earnings and returns under both scenarios. In fact, dollar discussions have been ongoing for some time, as we have been hearing from investors for the last several quarters that earnings are going to begin to surprise to the upside as the dollar strength appears to have played out and year-over-year comps will begin to look favorable. Though we don’t disagree that the dollar likely got ahead of itself last year, on optimism the US economy could decouple from the rest of the world, and much of the weakness recently is likely a resetting of those expectations, we do caution that with a June or July hike, the dollar is likely to rally once again.
However, outside of the impact such a move would have on oil (noted next) we believe the bigger issue is the untold story of why the dollar has been weaker. A weak dollar is not only suggestive of a more dovish Fed, but of poor growth. The unintuitive strengthening of the Yen and Euro in the face of unprecedented stimulus is likely not going to be a boon to earnings, but rather a hindrance, as global growth continues to slow.
We think investors make too broad an assumption that a weaker dollar will help earnings while in reality the effect of poor global demand on revenue could very well outweigh any FX benefit. For example, Q1 this year is supposed to be the first quarter where the dollar strength is washed out because of the 4% y-o-y decline in the dollar from Q1 2015 to Q1 2016. Yet, of the companies to have reported so far that have negative y-oy revenue (53% of all companies), 29% of their revenue comes from outside the United States. Contrast this with the 47% of companies that have reported positive y-o-y revenue changes, where just 17% of sales were generated outside the US. What we take this to mean is that a lack of global demand has taken on the mantle of headwind to large multinational corporates rather than FX headwinds.
Historically, this is consistent with past periods where we have seen that a weaker dollar is generally bad for revenue growth while a period of a stronger dollar tends to be good for revenue growth.
So although a weaker dollar may marginally help those companies who export goods and services, the reasons for the move is likely to have a bigger impact. And should the dollar strengthen, unlike past cycles where this meant underlying growth, in today’s world it is likely more a function of divergent central bank policies than a fundamental increase in demand, while also likely resulting in lower commodity prices.
4. Oil and commodity rally has limited upside
And with WTI now up 70% since February 11th, we question the amount of upside crude has from this point forward. As companies like Pioneer discuss ramping production at $50 and our commodity strategist calling for a drop in crude back into the $30s by late September, we think much of the trade this winter will likely fade and reverse. In fact, consider our credit survey on January 19th which showed that a net 80% of our clients were underweight the Energy sector to start the year. Yet despite such light positioning, the Energy portion of the market was able to sell off massively late last year and the first 6 weeks of this year. Now consider that as of March 24th the net amount of underweights had declined to 60%. Notably, however, our conversations with clients suggest that those who were looking to increase their energy allocation have done so. In our view, longer positioning means that if oil begins to fall again, Energy credits could meaningfully selloff once more.
If nothing else, the upside from Energy at this point is very limited. Our Energy analyst still believes nearly 20% of the sector will default this year and we have already witnessed 12 US defaults year to date. And with the high yield energy index rallying 15% in 2016 (and 41% since February 11th) we find it difficult to imagine a scenario where the contribution of Energy to total returns is significant from this point forward.
Our call for a -3% total return on the year for the sector would mean that the 41% rally would have to reverse itself by 50% in order to realize our total return forecast. Or in other words, investors who bought Energy on February 11th would still realize a 20% return despite Energy ending the year negative. Though a far fall from today’s levels, this scenario seems completely plausible to us if oil remains in the $35-45 range from here on out in the backdrop of deteriorating global fundamentals and, potentially, a demand picture that looks less rosy in 2017.
Although the beginning of the year selloff was one defined by concerns of recession, we must remember that to date, the oil collapse has been one that is defined by supply, not demand. And although 2015 realized one of the strongest years on record for oil demand, we are concerned that investors are taking for granted that the supply story will continue to be the only story of significance going forward.
5. Fundamentals are not only poor, but getting worse
However, as we have been saying since late 2014, the high yield story is so much more than an Energy story. And with every passing quarter, we see that non-commodity fundamentals continue to deteriorate. With negative EBITDA growth in three out of the last five quarters (Chart 7), earnings for these companies have been the worst we have ever seen outside a recessionary environment. And although we are only midway through Q1 earnings, when the highest quality issuers tend to report, we are already seeing signs that this trend will only continue as both top and bottom line growth remain uninspiring.
Among the 145 high yield issuers that have reported 1st quarter earnings and feed into our balance sheet calculations, 77 (53%) have reported negative year-over-year revenue growth compared to 45% in Q1 2015 and just 30% in 2014. In a similar vein, the number of issuers reporting negative year-over-year EBITDA growth is continuing to increase; 43% of Q1 2016 issuers so far have negative EBITDA growth, compared to 42% in 2015 and 34% in 2014. Even adjusted EBITDA, which we have shown can obfuscate the true underlying health of a company by hiding deteriorating asset values and losses to free cash flow, is showing a negative trend compared to previous years (Table 1). All comparisons are on the same set of issuers going back in time.
Although poor fundamentals do not necessarily lead to rising defaults, they do force issuers to become more dependent on free-flowing capital markets to source liquidity during times of need. But as we mention below, the riskiest issuers have been all-but shut out as the percent of triple-C issuers accessing the primary market is at its lowest level since 2010 (Chart 8). In our opinion, deteriorating fundamentals amongst ex-Commodity high yield issuers will ultimately prevail over the shorter-term technical backdrop, as names likely start to trade on news, downgrades and earnings once the euphoria of central bank action wears thin.
6. Maturity, refinance and default risk a bigger issue than appreciated
As earnings, revenue, and free cash flow deteriorate at a pace never seen before in an expansionary period, one of the oft cited reasons to be constructive high yield post February 11th is the belief that overblown recession concerns in January and February led to overblown default concerns. We disagree. Not only is the overall default rate now at 5.3% (as a percent of our high yield index, issuer-weighted, 4% par-weighted), but noncommodity defaults are also increasing (0.9% as of September 30th, 2015, 2% as of April 30th, 2016 on an issuer-weighted basis). Additionally, we already know that the riskiest HY issuers have had trouble financing themselves in the primary market for more than a year now and despite the recent rally, capital markets still remain relatively constricted for them. In our view, this means these borrowers’ risk of default is largely unchanged from before the rally.
And while those who are the riskiest borrowers don’t have access to capital, higher quality borrowers feel like low rates will be here indefinitely, and with few near-term maturities, figure why issue today when they can do so next year or the following: This is problematic for a variety of reasons.
First, we believe many CEOs and CFOs will face a difficult situation when they look to refinance nearly $450bn in bond and loan maturities by the end of 2019 ($249bn in bonds, $207bn in loans). If one considers that all signs currently point towards a looming default wave in mid-late 2017 (C&I tightening, the lack of triple C issuance, increase in proportion of downgrades to upgrades) it is hard to imagine open capital markets when nearly 25% of the entire leveraged finance market comes current at once.
Second, the premise that rates will not increase is potentially false. In fact, post the Fed’s April statement which sent market expectations of a June hike crashing, central bankers have been trying to maneuver expectations to neutral territory, insisting that a June hike is a real possibility. Our own economists’ base case is of a June hike and as mentioned above, we think this is a real underappreciated risk by markets. Though a hike may result in higher rates, we actually feel like it could just as easily and perhaps more likely, depress rates further, as the markets view the move as a mistake. In such a scenario, even if treasury yields remain low, capital markets even for high quality borrowers would likely freeze. If a crisis of confidence ensues, with few tools to fight a down market, high yield could see a prolonged period of low issuance and a lack of willingness to extend credit that outlasts even the highest quality borrower.
Third, even the near-term maturity wall is not as benign as many believe. Take a look at the maturity wall as it stands today. Granted peak maturities are still several years out, but the wall essentially looks the same as it did in 2008. And during this period longer dated maturities didn’t stop the ensuing default wave to precipitate credit losses.
Corporates would be wise to remember that they should build up cash while they can, for companies rarely default because they can’t make a principal payment. Instead, breaching a covenant or missing an interest payment is far more likely. And these events tend to happen when markets turn south, in our view a certainty over the next 18 months.
7. Tight credit conditions & poor earnings could spur slowing job growth/layoffs
As open capital markets have been taken for granted, despite defaults being on the rise, we have also seen banks begin to clamp down on lending standards to a degree that is suggestive of early stage credit tightening. Last year we wrote in our year ahead that should the senior loan officer survey show an increasing number of banks tightening lending standards in January, it was an ominous sign for a pickup in future defaults. At the time, our assumption was that we would see such a change on the back of global markets volatility. Sure enough, January 31st marked the 2nd straight quarter of banks tightening lending standards and Monday’s April 30th report confirmed several of our concerns from last year; that in the face of deteriorating corporate fundamentals, a weak economic outlook, industry specific woes in the commodity space and global markets that have been volatile, banks would pull back the reins on lending.
At the heart of all cycles credit availability defines booms and busts. And for this reason, we have argued that investors should look at high yield and credit markets in general to gauge the health of lending in this country and globally. And in a world where corporate balance sheets are arguably the most unhealthy they have ever been (all-time high leverage in HG and HY) where companies have relied on cheap debt to fund a growth through acquisition strategy, what happens if funding is either unavailable or too expensive to make a growth through acquisition strategy make sense? Same goes for buybacks and special dividends? Then one would have to cut capex. But with little capex to cut (Chart 10) personnel could be cut next (particularly if those people are beginning to cost more and as noted above, are less productive, Chart 11). And when coupled with a consumer that is already saving 5.5% of disposable income, should we see layoffs amidst an already low GDP, poor CEO confidence, and banks that are risk averse and perhaps hurting with commodity exposure, we are concerned that things could potentially get messy in such a scenario.
8. Low rates is not a new phenomenon and hasn’t drawn capital in the past
With such a poor fundamental and macro backdrop that is deteriorating by the quarter, coupled with valuations that don’t pay for the default risk, we recognize that the biggest draw to high yield at the moment is the lack of yield globally. However, the idea of low rates creating reach for yield behavior is not a new one, and we question how much more of an effect global easing will have now that the market has rallied substantially. Instead, in our opinion the reason for marginally lower rates (poor macro fundamentals) far outweighs the lower yields themselves and we believe investor sentiment will ultimately shift towards concern over the global growth picture rather than the hunt for income. As we have seen in the past, as the amount of negative yielding assets grew from $0tn to $9tn, high yield coincidentally sold off (Chart 10). Why wasn’t the market clamoring for yield at these already lofty levels?
High yield as an asset class isn’t generally suitable for ‘yield pick-up’ at this point in the credit cycle. As an example, take a Japanese investor willing to dip her toes in US BB corporates. It is important to distinguish that BBs is the likely spot for investment given rating constraints of many Japanese insurance companies and pension funds, as well as total return accounts in the US and Europe who may feel compelled to move down in quality. We assume that she swaps JPY principal into USD through a 5y JPY-USD basis swap and then swaps the floating LIBOR legs into fixed through 5y interest rate swaps. The yield on our BB index is currently 5.35%. Taking the cost of funding through the basis swap and the fixed-for-floating swaps, the net yield reduces to 3.2% – still very attractive given yields in the investor’s domestic market.
However, as we have stressed in the past, yield does not equal return, not in HY. The credit cycle has turned and defaults will continue to rise over the coming years. Over a typical cycle a BB cohort experiences 5y cumulative default rate of around 12%. When potential capital losses are taken into account, the above analysis starts losing its appeal. If the current BB cohort experiences a 12% default rate over five years at an average recovery rate of 30%, it will return a mere 2.5% per annum, less than half the stated yield. Taking the cost of funding into account that works to an annual ‘yield’ of 34bp for the Japanese investor, just about a tenth of what the market seems to be offering today and in fact worse than what’s available back home – the yield on our Japan corporate index is 41bp for a 4y duration.
While we can sympathize with the conundrum many investors face today in having capital but no yield, we caution that HY at this point in the credit cycle is a very risk proposition. We think US HG, with minimal risk of capital loss, is far more likely to benefit from foreign flows than US HY, and those who feel compelled to search for yield would be better served going out the IG curve, taking duration risk, rather than high yield credit risk.
9. Crowded trades with poor liquidity don’t end well
Despite our views on fundamentals and valuation, it has become painfully obvious that US HY is now a crowded trade. On a trailing 12w basis, retail funds have grown their assets by almost 8%, the highest 12w inflow since 2012. Our last investor survey, conducted in March, indicated that a net 22% of respondents were OW HY. While that may not seem like much at first glance, it’s up from 0% in November and is about as much as it was in September last year.
Even putting aside these numbers, it’s not hard to conclude that HY asset managers are now much closer to their benchmarks or overweight relative to earlier in the year. The average liquidity ratio for mutual funds has decreased by about 40bp between February and March and is likely to have gone lower last month. In addition, the initial leg of the rally was driven largely by short covering and had investors scrambling to get to benchmark weight.
Needless to say crowded positioning doesn’t help in the event of a downside shock; in HY the consequences can be particularly dire as we’ve witnessed over the last 18 months. Asset managers are unlikely to draw down their cash balances much further beyond current levels, given their concerns over redemptions. And the technical support of too much cash on the sidelines is likely petering out and would soon turn into the opposite problem of crowded overweights in an illiquid market.
Sticking to our view
We have been asked repeatedly over the last several weeks if we are sticking with our 0 to -1% total return view for 2016. Given what we have laid out in this piece, the answer is simply, “of course”. We are effectively calling for a 20% return in Energy from February 11th to December 31st despite a default rate that will likely approach 20%. And in non-commodities, our 0-1% target for the year would require about 150bp of widening in BBs and Bs and 350bp widening in CCCs assuming the 5y remains at 1.2%.
All this seems more than reasonable to us even absent a recession in 2016. Our view is that the Fed hikes in June or July and takes the market by surprise. Oil likely doesn’t get higher than $50/bbl on the year and likely sees sub $40/bbl again. Defaults are likely to be north of our forecast of 5-6% on an issuer basis, and on a par basis, will likely be right in line with our call. Even if the Fed doesn’t hike in June or July, September would pose the same risk, then December. And if none of those meetings yield a hike, the macro environment and markets are likely so bad that no amount of dovishness is going to help.
Our call in September 2014 was one on the credit cycle, not just a momentary pullback in valuations. Not only has our conviction on the end of the cycle increased throughout 2016, but now positioning and valuations have set up the market to realize a major correction at any future surprise. We may be wrong, but we think if we are, our mistake will be in under estimating the durability of the risk-on mentality induced by central banks. Though we question investor’s willingness to be compensated below 0% returns for default risk, and ultimately believe rational judgment and a lack of growth will prevail in causing spreads to widen again, it is possible that irrationality can outlast our 2016 return target. However, we believe the arguments laid out above will likely help to show that high yield, even for those that are starved of income, presents little in risk-adjusted return. And for this reason, 0 to -1% total return feels just about right to us.
via http://ift.tt/1q41ydb Tyler Durden