Credit Markets: A Look at the Bigger Picture

Around the Curve

Credit Markets: A Look at the Bigger Picture

To understand risk, it is important to look at the below-investment grade market in its entirety – including both bonds and loans.



Much ink has been spilled discussing and analyzing lower-quality corporate credit markets, particularly in the U.S. However, we think credit markets globally will also continue to develop and evolve as investors grow increasingly interested in this segment. Investors will face both opportunities and challenges as global credit markets develop, evolve, and mature. Therefore, investors must continually ensure they understand the risks they are bearing. We think looking at the U.S. high yield market is a good place for investors to start when evaluating risk and opportunities within global credit markets, because these trends have broader applicability.

In order to understand risk, it is important to look at the below-investment grade market in its entirety by including both bonds and loans within the scope of this universe. When looking at these markets on a combined basis using Bank of America Merrill Lynch (BAML) data since 1996, the composition of the high yield credit market has grown from an initial $179.9M in bonds and $13.6M in loans, totaling $193.5M, to $1,132.9M in bonds and $1,049.9M in loans, for an aggregate $2,182.8M. Clearly the U.S. high yield credit market has grown dramatically over the last two decades. While there has been a material increase in loan issuance, we will explore that specific issue at another time. When only looking at the tradeable bond market, the size of its growth has been subdued since 2014-2015 while loans have seen significant growth. See Chart 1 below:

 

As of 5/31/2018. Source: Brandywine Global, BofA Merrill Lynch Global Research, ICE BofAML Bond Indices, S&P LCD. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

As the market flows continue to change as illustrated by these two charts, loans have seen a steady inflow as high yield bond flows have remained muted (see Charts 2 and 3).

 


 

Source for Charts 2 and 3: Brandywine Global, Morgan Stanley Research, EPFR. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Lessons

We believe the changing dynamics between loan and bond flows may mask risks within the world of credit—which is an important reason why both asset classes should be considered in tandem. For example, leverage has recently been increasing for both loans and bonds, with a more significant uptick in gross leverage across these asset classes. As illustrated in the chart below, gross leverage for the loan market has increased from 3x earnings before interest, taxes, depreciation, and amortization (EBITDA) in 2002 to just under 5x EBITDA in 2017, whereas leverage for bond issuers is near its all-time highs at approximately 4.5x EBITDA (see Chart 4).

 

Please Note: Dark green line = Gross Leverage, Khaki line = Net Leverage. Source: Brandywine Global, Morgan Stanley Research, Bloomberg, CapitalIQ, S&P LCD. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

While it appears as though leverage has started falling over the last two years, gross and net levels still remain high, giving us pause for concern. The next chart below shows that gross leverage remains near those two-decade highs. Since gross leverage continues to hover at these high levels, we believe credit investors should proceed with caution, particularly as the Federal Reserve (Fed) continues down the path of normalization via rate hikes and balance sheet reduction. Moreover, the last 10 years of data shown in Chart 5 below may be an anomaly given the unprecedented level of monetary stimulus issued during the financial crisis. Therefore, historical data mining may not result in the same outcomes as the data below suggests, which would be a return to pre-crisis levels (see Chart 5):

 

Source: Brandywine Global, Morgan Stanley Research, Bloomberg, Capital IQ, S&P LCD. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Usually, a recession corrects a meaningful uptick in leverage, as was the case in 2002. Despite a flattening U.S. Treasury yield curve, there aren’t any imminent signs of recession to correct high debt ratios. In fact, late-cycle fiscal stimulus should give the U.S. even more momentum going into 2019. With leverage in the U.S. at or near highs, it is prudent to understand credit exposure as Fed policy continues to evolve. These conditions warrant keeping an eye on two key factors: interest coverage ratios and duration.
 

Conclusion

As U.S. monetary conditions tighten, it's important to look for quality companies—which goes beyond credit ratings when considering high yield opportunities. A quality business means manageable outstanding debt, asset protection, strong balance sheets, cash generative, and a good business model. Today, opportunities in debt should also have a shorter duration profile relative to investment grade corporate credit and sovereign bonds. Generally, in our opinion, these are attractive characteristics that any investment opportunity should have around the world at this point in the credit cycle. As the U.S. credit cycle matures, investors should be increasingly selective about opportunities. When considering credit markets outside the U.S., the signals remain the same: the direction of monetary policy and gross leverage for both loans and corporate bonds.

 


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A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.