Credit Selection in a Late-Cycle Environment
Rebecca Young, Portfolio Manager on the Strategic Fixed Income team, shares her views on the topical issues in credit markets, explaining where she and the team see risks and opportunities.
Economies do not grow evenly; there are ups and downs as an economy moves through the different stages of expansion (growth) and contraction (recession). Business activity follows the same patterns. The latest global economic expansion began nearly 10 years ago, and we firmly believe it is “late stage,” although it would appear that we are far from alone in this view. A record 85% of investors surveyed in a recent fund manager survey1 think the global economy is in late cycle (11% higher than the previous high in December 2007).
Late cycle can be a difficult time for credit investors as spreads tend to widen, completing a bottoming process ahead of a peak in equity markets. Hence, investors need to be vigilant of the downside risk for individual credit holdings. When looking specifically at the developed world credit markets, there are certainly a number of trends worth monitoring closely, and these are currently warning us to tread carefully.
Beginning with Global Leveraged Loans …
Leveraged loans are loans to heavily indebted companies. The Bank of England recently warned that the leveraged loan market is now “larger than – and growing as quickly as – the U.S. subprime mortgage market was in 2006.” Leveraged loans should continue to benefit from their senior, more defensive position in the capital structure. However, the legal protections for investors to be able to hold borrowers to account should the financial performance of a business falter have been significantly eroded, with nearly 80% of the U.S. leveraged loan market now “covenant-light.” This is up from less than 25% in the 2006-07 era.2
We have witnessed leverage levels creeping higher and “loan-only” structures becoming more prevalent. These are structures that lack a junior high-yield bond component, which would normally provide loss absorption in the event of a default.
Thus, it is not surprising that the average credit quality of the U.S. market has deteriorated, with approximately 64% of the outstanding stock now rated mid-single B or below versus 47% of the market in 2006.
… Switching to Bonds and the High-Yield Market
In Europe this year, we have been monitoring the rising level of dispersion, with a growing number of individual bonds experiencing large price drops. There are now nearly 70 bonds year to date that have dropped 10 points or more (Exhibit 1). Avoiding these large potholes has been crucial for capital preservation. Interestingly, the ICE Bank of America Europe High Yield Index return has held up relatively well, declining 1.4% year to date (to October 31, 2018, in local currency terms), but when you dig down a little deeper under the surface, things are not as healthy as they first appear.
Exhibit 1: European High-Yield Market: Change in Bond Prices Year to Date
Next: The Growing Size of BBBs
Another frothy area of the credit market that has caught our attention is the growing size of BBB-rated debt (the lowest tier of investment grade). This phenomenon has played out across Europe and the U.S. in this cycle, including where companies have voluntarily added debt to their balance sheets through merger and acquisition (M&A) activities.
The primary concern here is one of relative size of the BBB market versus the BB-rated category (the higher credit rating bucket of the junk bond market), where, for example, in the U.S. the former is 4.3 times the size of the latter and compares to twice the size 10 years ago.
The rapid growth of BBB markets in Europe and the U.S. can be seen in Exhibit 2. In the next downturn, there will inevitably be some downgrade activity from BBB to BB, but will the BB category suffer from indigestion as it is forced to absorb these downgrades?
Exhibit 2: Rapid Growth of BBBs
So Where Can We Take Shelter in the Credit Markets?
Given this backdrop for credit, we believe a focus on higher quality credit and government bonds at the expense of high yield credit would be sensible. However, there are still a few positive themes to be explored in the high yield market.
One such theme is that of “rising stars,” companies where there is confidence in the health of the underlying business, and which may be transitioning from high yield to investment grade. Over this journey, credit spreads seem to tighten and bond prices rise, providing a potential income and capital appreciation opportunity. Tesco would be an example of this dynamic, having recently obtained their first investment grade rating from Fitch. The company has been actively tendering for bonds in the market to strengthen their balance sheet and are on track to achieve a second investment grade rating in 2019. Two investment grade ratings provide for a positive technical backdrop as bonds see demand from a whole new buyer base since the securities become investment grade index eligible.
Elsewhere in the markets, mergers and acquisition (M&A) activities could provide opportunities. Specifically companies with good business fundamentals where there is the potential for a positive catalyst through M&A activity. For example, the high yield German cable company Unitymedia, which benefited earlier this year when Vodafone agreed to buy the company. The news sent Unitymedia bond prices higher given that the bonds will be absorbed into the higher quality, investment grade capital structure at Vodafone on closing of the deal.
In summary, credit positive stories are certainly becoming harder to find in this late-cycle environment but they do still exist.
1Bank of America Merrill Lynch Global Fund Manager Survey, October 16, 2018
2Moody’s Investors Services, “Leveraged finance – US: Convergence of bonds and loans sets stage for worse recoveries in the next downturn,” August 16, 2018.
Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
Rising stars are bonds that were considered speculative, but have since improved their financials, reducing the risk of default. These bonds are now closer to investment grade status.