Around the Curve

U.S. Credit Cycle: Late Innings

By Brian Kloss, JD, CPA
23 September, 2019
The U.S. credit cycle may be in the late innings of the game, but there are still some good plays left.
Using the proverbial American baseball analogy, the U.S. credit cycle is in the late innings of the game, but there are still some good plays left. Managing these later stages requires skill, and it becomes a game of careful security selection in certain asset classes. Investing in a mature credit cycle also means that managers should look for end-of-the-cycle signals like a rising default rate, weighing the benefits of defensive characteristics versus attractive valuations, and anticipating monetary and fiscal policy responses.

Defaults

We find that looking at forward default rates provides insight into the potential for risks within the U.S. credit market. Although the model as shown in Chart 1 below does not forecast a significant uptick in defaults, we suggest that investors be mindful of increasing distress ratios. In the short term, defaults will remain muted as the volume of debt that matures in the next year is reasonably manageable since companies have termed out their debt and loose covenants provide these borrowers with flexibility in managing their balance sheets. The absence of a looming debt maturing wall and lighter covenants signal that the end of the credit cycle may still be a couple of innings away.
Sources: Bank of America Merrill Lynch, Brandywine Global. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Valuations

Given that we are in a mature U.S. credit cycle, valuations across this asset class have not necessarily offered significant value, although there are select sectors and quality strata that do. In particular, we believe there is relative value in U.S. high yield versus investment grade credit, as illustrated (Chart 2) by these option-adjusted spreads:
Sources: Bank of America Merrill Lynch, Brandywine Global. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Credit investors can therefore have more defensive positioning within the high yield sector and pay a smaller premium relative to investment grade corporate bonds. Nevertheless, valuations across the corporate quality spectrum, using historic metrics, appear to be fully valued. With many global spreads at or near all-time “tights” (see Chart 3 below), we suggest that investors focus on better credit quality within the high yield sector and also manage duration through rolling down the yield curve.
Sources: Bank of America Merrill Lynch, Brandywine Global. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Based on Chart 3, we believe there are opportunities in the single-B credit quality segment of the U.S. high yield market. As mentioned earlier, this is a game about prudent security selection. Therefore, shorter-duration credits issued by companies that are refi-eligible should benefit from easier Federal Reserve (Fed) policy. In this environment, investors may be also contemplating whether to fully allocate to more defensive positions or also consider positions in higher-yielding opportunities that have more attractive valuations. We don't think there should be a tradeoff between the two, as there are also opportunities in emerging market sovereigns on a country-by-country basis.

Opportunities

We expect many central banks around the world to participate in broad-based easing, as the global inflationary backdrop remains relatively benign. Weak inflation in most developed markets has been offset by stable-to-modestly higher inflation in emerging markets. As monetary policy potentially shifts, an emerging market allocation might be the appropriate complement to defensive U.S. credit positioning. Furthermore, several governments have also announced plans to earmark parts of their budgets for fiscal stimulus. The increase in government spending to help offset any potential decreases in business investment in the face of flagging global growth. The Fed's slow tilt toward dovishness should also foster a more constructive environment for emerging markets. We will be looking for countries with improving current account and fiscal balances and that offer local-currency bonds with an attractive carry. Given the factors outlined, we believe this stage of the game warrants careful security selection in both emerging market sovereign bonds as well as the U.S. high yield credit market.

Definitions:

Estimated Forward Default Rate is the rate (%) determined by result of an analysis of the factors affecting the future default of a class or sector of fixed income securities with the potential for default in the future.

Realized Annual Default Rate is the rate (%) of default of a class or sector of fixed income securities based on the actual, observed rate of default.

An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

“Tights” refers to the level of spreads between two series.  A “tight” is a small spread. “Record tights” refers to levels of tightness that set some form of record low level.

The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.

A company may be deemed “refi-eligible” if its debt or overall financial position has attributes making it eligible for refinancing.

The JP Morgan Corporate Emerging Market Bond Index (CEMBI) is a global, liquid corporate emerging markets benchmark that tracks denominated corporate bonds issued by emerging markets entities.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change of 100 basis points. It is calculated as the weighted average of the present values for all cash flows.

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

current account balance summarizes the flow of goods, services, income and transfer payments into and out of a country

Carry refers to a differential in interest rates across sectors, such that tactical profits could be generated by trading between them.

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