US credit investors on the defensive amid late cycle lending

Investors in US structured credit and leveraged finance are bracing themselves for bouts of volatility and growing idiosyncratic risk, as spreads grind to record tight levels while aggressive underwriting behaviour increases, writes David Bell.

  • By David Bell
  • 30 Nov 2017
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Outgoing US Federal Reserve chairperson Janet Yellen described economic expansion in the US as “increasingly broad, based across sectors as well as much of the global economy”, in her last appearance before the US Congress on Wednesday. 

Economic growth has stepped up from its “subdued” pace earlier in the year, she pointed out, a trend that might help extend an already drawn out bull run in debt markets.

But despite the benign macro backdrop, US credit investors are preparing for volatility to increase and spreads to widen next year, with the Fed raising interest rates and unwinding its $4.5tr of assets bought through quantitative easing.

Default rates in high yield and leveraged loans are expected to double to 2.5% next year, according to Peter Acciavatti, head of high yield research at JP Morgan, speaking at the bank’s fixed income markets 2018 outlook in New York on Tuesday.

This will be driven by one or two large names, which are already priced into the market, he said.

“Absent these situations, default activity on an issuer basis is expected to be flat year-over-year,” he wrote in an accompanying research note.

Idiosyncratic focus

But idiosyncratic credit risk is becoming a bigger concern, even if credit investors generally seem comfortable with macro conditions.

“Doubling default rates can sound alarming — but to put that into context, it’s still substantially below the 25 year historical average,” said Erika Morris, portfolio manager at Semper Capital in New York. 

The average long-term default rates in high yield and leveraged loans are 3.5% and 3.3%, respectively.

“We think the market is in a very late [part of the] cycle, and defaults should start rising in late 2018 and early 2019,” she added.

The brief bout of volatility in the high yield market in November, when indices rapidly dropped and then recovered could be a sign of things to come. 

As borrowers turn the screw tighter on pricing, increase leverage and build in weaker covenant structures, investors are showing signs of impatience with any indication of corporate underperformance.

“We expect to see an increase in idiosyncratic risk in 2018,” said Tom Ross, co-manager of the global high yield bond strategy at Janus Henderson, in the firm’s 2018 outlook last week. “We have already noticed this in the second half of 2017, starting with the volatility in the telecoms sector in August, as merger and acquisition rumours and stories were rife.”

“Certain sectors are more exposed,” said Morris, pointing out telecoms, retail, pharmaceuticals and healthcare as key sectors of concern. “Generally we are neutral on cable and telecoms companies, which is the largest single sector of the high yield market. It has become a very concentrated industry, and a few negative headlines can take down the entire sector.”

Energy is also a concern, given its exposure in the high yield and leveraged loan markets. Morris said she expects to see defaults rise when oil prices fall to levels around $35 a barrel, a level they last hit in early 2016, when defaults spiked and CLO managers were burnt by a market sell-off.

“This far into a credit cycle, people don’t feel they should be taking too much credit risk. CLO managers are generally managing portfolios to minimise credit mistakes rather than taking aggressive positions in discounted names,” said Mike Herzig, managing director at THL Credit, in a recent interview. “The main reason is the impact of the energy sector two years ago. The loan managers who got energy wrong then have been wary of what happened.”

Head for safety

Analysts speaking at JP Morgan’s fixed income conference largely recommended credit investors move up the capital structure in their respective asset classes. 

CLO analyst Rishad Ahluwalia said that CLO mezzanine debt was vulnerable to any pull-back in high yield or broader credit markets, and recommended targeting the safest triple-A rated bonds. “Boring is good,” he said.

Similarly, CMBS analyst Gareth Davies said that now was the time to “take chips off the table and invest in more defensive products”.

Underwriting standards in the CMBS market are expected to worsen next year as lenders compete with other forms of commercial real estate finance to help sustain deal flow. More than $100bn of pre-crisis debt matured this year, boosting deal volumes as it was refinanced, but just $9.6bn of loans are scheduled to mature next year.

Collateral quality is already starting to worsen, based on stressed loan to value ratios and debt service coverage ratios, said Davies. “We expect this to continue to decline as CMBS looks to close the collateral gap next year,” he said at the conference.

Non-bank lenders hold the bag

According to a report from Guggenheim this week, the next recession might not start until between late 2019 and mid-2020. This could give credit investors some breathing room before spread widening and volatility moves beyond idiosyncratic issues into a wider market downturn.

“Risk assets tend to perform well two years out from a recession, but investors should become increasingly defensive in the final year of an expansion,” they said.

Unlike the last financial crisis, the next one is likely to hit risky corporate debt, an asset class that is overwhelmingly held outside the banking sector.

A report from S&P Global on Wednesday said that 84%-88% of newly issued highly leveraged leveraged loans have been bought by insurance companies, hedge funds, and high yield mutual funds since 2012. US banks accounted for just 4%-7% of the investors in each deal during that period.

In contrast to strong consumer credit fundamentals — where borrowers have delevered greatly since the financial crisis — corporate leverage (measured as net debt to Ebitda) has climbed to its highest level in the past two decades, according to Matthew Jozoff, head of securitized products research at JP Morgan. 

“If you are looking for the next crisis, we don’t think it will come from the consumer,” he said at the bank’s fixed income conference this week.

And according to the S&P report, the longer a supportive macro backdrop encourages aggressive lending practices, the worse the fall-out will be when the market does turn.

“[The] longer volumes remain elevated and underwriting is aggressive, the greater the eventual losses that may result,” wrote the analysts.

  • By David Bell
  • 30 Nov 2017

GlobalCapital European securitization league table

Rank Lead Manager/Arranger Total Volume $m No. of Deals Share % by Volume
1 Bank of America Merrill Lynch (BAML) 7,026 25 11.95
2 Citi 6,449 21 10.96
3 BNP Paribas 5,093 18 8.66
4 Barclays 4,040 11 6.87
5 Lloyds Bank 3,615 14 6.15

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1 Citi 1,712.34 6 12.44%
2 SG Corporate & Investment Banking 1,292.64 1 9.39%
2 Rabobank 1,292.64 1 9.39%
4 Mizuho 1,215.54 3 8.83%
5 Wells Fargo Securities 1,012.71 4 7.36%