The cycle turns
By Alex Veroude, Insight Investment
Rising volatility, increased leverage and escalating defaults all suggest a challenging backdrop for fixed income in 2016, but do recent data point to a credit cycle tipping point?
On the surface at least the current environment for credit seems robust. Flows into bond funds in the US alone have topped US$1.5 trillion since 2007, according to the Investment Company Institute. Issuance through much of 2015 has also been at record levels, with US$129bn of US investment grade credit coming to market just in July, traditionally a quiet month. US$800bn had been issued in 2015 by the third quarter.
High yield issuance was also at record levels over the past year. Since 2010 it has doubled in the US to around US$300bn per year, according to credit rating agency Fitch. In the first eight months of 2015, high yield bonds in Europe accounted for 16% of all issuance, compared to just 3% over the same period in 2014.1
This level of investor demand for yield is seemingly insatiable but it is also unsurprising in our view. At one point in mid-2015 US$4 trillion of debt globally traded at negative yields and, at their lows, French, German and Swiss sovereign yields were negative out to five, nine and 15 years respectively.2 Investors who traditionally have been happy to pick up positive real yields from risk-free assets have been forced to venture into corporate bonds to get equivalent returns and ever further down the credit spectrum.
This approach has worked reasonably well in recent years, but now we believe there are signs of strain. By the third quarter of 2015 the Barclays US Credit Index had eked out just a 5 basis-point return whereas intermediate US Treasuries (7-10 year) were up 2.4%.3
There are other signs of the credit cycle turning as we head into 2016. So called ‘cov-lite’ bonds and leveraged loans, for example, are emphatically back in fashion.4 In the US, by the third quarter of 2015, 76% of issuance of leveraged loans were cov-lite; the equivalent figure in Europe was above 50% for the first time to the same period.5 In short, risk has been transferred from issuers to borrowers. A similar picture can be seen in overall credit quality. US corporates rated single B or below increased to 72% by the third quarter of 2015; up from 58% in 2009, according to rating agency Moody’s. Standard & Poor’s, meanwhile, reported that speculative grade corporates (rated BB+ and lower) issued 80% of all new debt in the US in 2014, up from 45% in 2008.
JP Morgan points to corporate net and gross leverage increasing since 2012 and currently standing at levels last seen at the height of the tech, media and telecoms bubble in 2000. In our view, such developments, though arguably extreme, are typical of the latter stages of credit cycles. They are also unfolding against a backdrop of great macro uncertainty. The squalls in credit and developed equity markets in 2015 were trivial compared to the volatility storm faced by emerging markets. Credit managers that lived through 2007 will find some aspects of current markets eerily reminiscent. However, whereas then there was maximum bullishness, today there is a far greater appreciation of potential downside risks. Perhaps the best gauge of this pervasive sense of uncertainty is Moody’s prediction for future defaults (see Figure 1).
In our view, the gap between the base case spelled out on the chart and the pessimistic case is wider than it has ever been.
Looking to 2016, we continue to believe there are three areas where credit investors can still expect to generate reasonable returns over the medium term. The first is a question of strategy rather than assets.
The flexibility to be long and short of different parts of the credit universe, using single name and index-related credit default swaps for short exposure, empowers a manager to precisely calibrate risk and only take exposures where he or she has high levels of conviction.
We also believe long-term investors should be prepared to trade perceived liquidity for illiquidity and transparency for complexity. Those who remember 2007 will recall the credit crunch was like a bolt of lightning from a clear sky. We believe it may be best to head for safer ground now.
1.Fitch ratings data as of August, 2015
2.Bloomberg, September 2015
3.Barclays data as of 20 September, 2015
4.‘Cov-lite’ bonds are those whose covenants (terms and conditions) offer lower protection for investors.
5.Bloomberg, September 2015