Money Matters

Be wary of ‘gradual, then sudden’ fissures in credit

Money Matters
By Michael Mackenzie
Mon, 12, 18

When credit starts looking dicey, investors quickly pay attention and for good reason. The malaise afflicting European and US credit markets summons unpleasant episodes from the past.

When credit starts looking dicey, investors quickly pay attention and for good reason. The malaise afflicting European and US credit markets summons unpleasant episodes from the past.

Some have tagged the woes at General Electric as a harbinger of a major reckoning, just as the downgrading of US carmakers Ford and GM in 2005 triggered a credit spasm that year. One duly forgotten until 2008 dawned.

The other chilling credit memory beckons from the bursting of the tech bubble at the turn of the century, a reckoning that was milder than what we saw during 2008. Still, this period was characterised by investors suddenly hustling to leave credit, only to find a narrow door and plenty of company.

As 2018 draws to a close, US and European investment-grade and high-yield benchmarks are all down for the year in total return terms. You need to go back to 2008 for the previous time corporate credit was in such a funk.

When equities began their swoon in early October, credit was initially resilient. This supported the idea that shares were experiencing a welcome correction.

But in recent weeks, risk premiums for US and European credit, as measured by spreads over government bond yields, have climbed to levels previous seen during the summer and late 2016.

Judging by the volume of downbeat outlooks for 2019, credit worries plenty in the City and Wall Street; namely we are heading into a typical late-cycle period where the excesses of corporate borrowing come home to roost, an outcome that usually surprises many investors accustomed to the good times.

For example, euro investment credit spreads have widened this year, as the European Central Bank will soon end its purchases of corporate bonds, having bought €175bn of such paper since June 2016. In turn, euro high yield has been hit harder.

With quantitative tightening gaining speed, fissures in credit have not escaped the attention of some investors.

Andrew Milligan, head of global strategy at Aberdeen Standard Investments, said he had been looking at the dip in European high-yield and emerging market credit as a degree of forced selling was creating opportunities. But he remained wary of US and European investment-grade credit because of high levels of leverage. As for US high yield, the fallout from the oil slump casts a lengthy shadow given the hefty weighting of the energy sector, argued Mr Milligan.

For long-term credit investors, the story comes down to whether they get their money back over time from companies. A moderating economy that still allows groups to generate profit growth means that recent credit weakness can stay contained.

Of course, the unique aspects of this credit cycle, such as a record expansion in size, longer maturities, lower investor protections and weaker rating quality, are also accompanied by other profound changes.

Trying to sell corporate bonds has never been easy and tougher regulations for banks has diluted their role in facilitating investors heading for the exit.

On top of that, there is a lot more credit exposure in the form of baskets such as exchange traded funds. As we have seen, this can exacerbate selling pressure across the broad credit market.

Against that dynamic what really worries many in the market is the expansion of triple B-rated debt, now running at $2.5tn, up from $670bn in 2008.

The explosive growth of lower-rated investment grade paper — it represented a third of the US market in 2008 and now accounts for half of both the US and Europe IG universe — illustrates the borrowing binge by companies against the backdrop of low interest rates that encouraged investors to secure fixed-rate returns via corporate bonds.

With willing buyers, private equity and dealmakers have taken full advantage of easy financing and a record mergers and acquisition boom.

But as Fidelity highlights, the growth in leverage in the US BBB market versus Europe is hardly a comforting picture. A slowing pace of corporate profit growth will increase the market’s sensitivity to balance sheet stress.

Many companies probably face a tough time improving the quality of their balance sheets as the economy slows next year, with the danger that cost cutting becomes a stronger headwind for broad activity and duly saps credit sentiment.

The challenge for credit investors is trying to gauge how much triple-B paper ultimately becomes junk, a repricing that may well land us between the past two credit busts in terms of losses and volatility.