The key to navigating the credit cycle, according to Brad Rutan, Investment Product Specialist at MFS Investment Management, is anticipating inflections, repositioning early and being patient. As the credit cycle ages, the lending conditions loosen, the leverage rises and there is a tight dispersion in spreads across sectors and rating tier. It is getting late in the credit cycle, and investors should be reducing their risk exposure before there is a cycle contraction and the liquidity dries up.
“This late in the credit cycle, if investors wait to reduce risk until spreads start to dramatically widen, there will be no buyers for their risk. During a cycle contraction, the credit availability tightens, the refinancing risk increases, and the default rates spike. There is a "flight to quality" in credit and the weaker credits underperform, if not incur in default. Investors need to have their fixed income portfolios prepared for that event,” explained Rutan.
Over the past decade, while high yield corporate spreads have been declining, spread widening events have been smaller and shorter in length. In 2011, spreads reached a peak during the European debt crisis, in 2015 and 2016, spreads widened when commodity prices fell apart, and more recently, in the summer of 2018, spreads peaked again. Despite these mini-cycles have created opportunities for active managers, in each of these mini-cycles, the high yield corporate spreads have been peaking at a lower point, confirming the declining trend in spreads and indicating that the cycle is “running out of gas”.
Where are the risks at this point in the cycle?
There have been significant changes in the composition and quality of the investment grade universe of bonds. In the last two decades, the credit quality composition of the Bloomberg Barclays US Credit Index has changed dramatically.
“Over the last 20 years, the AA debt universe has been cut in half, from 20% to 10%, the single A debt universe dropped by 8 percentage points, from 44% to 36%, the BBB debt universe has grown 15 percentage points, from 30% to 45%. Why is the BBB debt universe so big today? Looking at the AA and A debt universes, one can see that there has been a massive downgrade cycle as companies have increased their debt levels. US companies have been playing the game with rating agencies, knowing how much debt they can accrue and what promises they can make to not to get downgraded to the next step below BBB, which is high yield bonds. Some investors believe over 300 billion US dollar of BBB rated debt could be downgraded to high yield, but they are not being downgraded because, normally, the rating agencies are very reluctant to downgrade at this last step to BB debt”, described Rutan.
By sectors, Telecom companies accrue the largest amount of BBB debt that were previously rated as single A or higher, followed by Health Care companies and Utilities.
“The high yield market is already worth a trillion US dollar. If, eventually, this 300 billion US dollar of BBB rated debt is downgraded to high yield, it will be adding a 30% of bonds supply to a market already illiquid, probably implying a very messy price discovery process”, he added.
On top of that, during the last six years and unlike previous periods, there has been a big disconnection between the high yield spreads, the compensation of high yield over Treasuries, and the corporate debt levels, measured by the corporate debt to GDP ratio.
“Since 2012, corporate debt levels have been growing steadily, being now over the last peaks set in the last previous recessions of 2001 - 2002 and 2008 - 2009. Meanwhile, the high yield spreads are moving in the opposite direction. Spreads should be above their current levels and getting to the point they should be is going to be an ugly process.”
Are investors compensated for high yield risk today?
When the risk of default is considered, reducing the spreads of the CCC rated high yield debt over Treasuries by the expected losses, the loss-adjusted spread is negative. That is the reason why MFS IM has sold all their positions with CCC rating in their total return bond strategy.
Also, the search of yield and higher rates have increased the demand for banks loans, but this asset class is not as attractive as many investors think it is. Their quality has been declining, they offer less protection to the creditors and they have lowered their projected recoveries.
“Bank loan’s attractiveness lies on that they are floating rate instruments and they provide a great hedge against rising rates. They also sit above bonds in the capital structure of a company, if the company defaults, the bond investor should take the first hit and the bank loan investor should have a buffer against losses. But, unfortunately, 60% of high yield companies have a loan-only capital structure, therefore, there are no bonds to act as a buffer. Regarding credit quality, the percentage of issuers that are rated single B or lower has risen over 65% in 2018 from 48% in 2006. In addition, about 75% of the bank loan market lacks sufficient covenants which diminishes the protection of creditors and the projected rates of recovery are below the average historical recovery rates.”
Why investors should be positioned ahead of volatility?
Credit spreads across asset classes and geographies are low, investors are getting lower compensations for the same amount of risk and it is getting much more difficult for asset managers to identify and properly risk bonds.
Moreover, the market has grown in size, but less participants are willing to make a market. Since the Dodd-Frank reform was enacted on July 2010, the inventories of the primary dealers have decreased by 90%. The assets of corporate bond mutual fund and ETFs have grown by 136% and the average trading volume per year has increased by 85%, but the primary dealers have gone, and this may represent a liquidity problem in the case of a stressed credit event.
Where are the opportunities?
At the short end of corporate curve, investors can better withstand higher yields before they incur in losses. The breakeven yield is currently higher at the short end part of the curve. That is where investors have the best protection against raising rates and where they are more compensated for the risk that they are taking.
Also, the diversification benefits have been more pronounced in traditional fixed income sectors. Investment grade corporate bonds, municipal bonds, and the Bloomberg Barclays US Aggregate Bond Index have had a lower correlation with equity in the last five years than high yield bonds, bank loans and emerging market debt. A lower correlation with equity translates into higher average returns whenever the equity market experiences a pullback of 5% of greater.