This update looks at the key trends in credit spreads and issuance, default rate forecasts, and strategies to consider in your portfolio
Since we published our last credit outlook in mid-January, there has been plenty to keep investors interested in financial markets. There has been a surprising increase in volatility across asset classes – equities, government bonds and credit markets
Figure 1: S&P500 and ASX200 (year to date 2018)
Figure 2: 10yr US Treasury and 10yr Australian Government bond yields (year to date 2018)
Figure 3: Credit spreads – Australian iTRAXX, US CDX IG and US CDX HY (year to date 2018)
In summary, equity investors have been getting increasingly nervous by the higher US government bond yields – the 10yr UST traded above 3% for the first time since January 2014 and hit 3.10% in mid-May (the highest since July 2011) – and the impact that this may have on future equity prices and returns. There were also several geopolitical issues that taxed investors, these included North Korea, China and Syria.
In this note, we focus on what we believe to be the key credit drivers over the next 6 to12 months.
Credit fundamentals
Federal Reserve’s senior loan officer survey
One of our key leading indicators that can drive future corporate default rates is the availability and price of credit. By this we mean, for a company, how easy and how expensive is it for it to get funding from a bank. In this regard, the Federal Reserve publishes an insightful quarterly survey (January, April, July and October) on US bank lending practices. The latest survey, published in April 2018, covered responses from 72 domestic banks and 22 U.S. branches and agencies of foreign banks.
Figure 4: Net percent of domestic respondents tightening standards for commercial and industrial loans
Figure 5: Net percent of domestic respondents increasing spreads of loan rates over bank’s cost of funds
The last two quarters continued the trend seen during the last two years and show that banks, on balance, have eased their standards and terms on commercial and industrial (C&I) loans to large and middle-market firms, and left their standards largely unchanged for small firms. Also adding to the positive backdrop was that over the first three months of 2018, the banks eased most terms on C&I loans to large and middle-market firms and to small firms. In addition, a significant portion of banks reported lower loan rate spreads on loans to large and middle-market firms, and a moderate portion narrowed spreads on loans to small firms.
This is a very similar message in Australia. Each quarter, the RBA publishes the spreads that banks lend to large and small businesses. The figure below shows that the margin to large businesses has seen substantial contraction from 250bp (in December 2011) to 195bp (in December 2018). For small businesses, the margin has remained largely unchanged and moved from 375bp (in December 2011) via 415bp (in December 2012) to 380bp (in December 2018). This indicates that Australian banks have reduced the margins that they charge large businesses more than small ones – this is shown by gradual increase in the differential line below.
Figure 6: Margins on Australian bank lending to businesses
Default rates
Generally default rates are recognised as a lagging indicator of movements in credit spreads. However, the fact that they are currently below long-term averages and are expected to fall further in 2018 indicates that the broader credit environment continues to remain supportive.
S&P expects the US corporate trailing 12-month high yield default rate to decrease to 2.6% by December 2018 from 3.1% in April 2018. By December 2018, in S&P’s optimistic and pessimistic scenario, the default rate to falls to 2.2% or rises to 3.8%, respectively. Within that forecast, S&P expects the energy and natural resources and consumer/service sectors to continue to experience heightened credit stress, with energy and natural resources accounting for over half of all defaults in the US in 2016.
Figure 7: US trailing 12-month high yield default rate and December 2018 forecast
Credit technicals
Over the first few months of the year, technicals in the credit market have certainly been more mixed than expected at the start of the year, with investor sentiment proving to be as skittish as the US stock markets. This is a change from the relatively positive demand dynamics that existed in 2017 and has been evident in Lipper data flows for US high yield mutual funds. These fluctuations in investor sentiment have been highlighted by an inflow of about USD3bn in mid-April, but a USD11bn outflow in late-February (the second highest outflow on record); up until the end of March, high-yield bond funds have had net outflows in 10 of 13 weekly periods, totalling roughly USD18bn.
As a result, some high yield new issues have received strong investor demand – deals have been upsized and priced below initial price talk – but others have priced at the wide end of the range or have been delayed.
Having said that, we still expect the bond supply to be absorbed by investor demand; we believe that although investors are becoming more cautious, they are still looking for relatively higher returns amid very low interest rates. At the moment, investors seem happy to chase the yield dragon.
The figure below shows that US high yield issuance declined for four straight years to 2016, after peaking at the 2012 high of USD290bn. However in 2017, high yield issuance was USD236bn and beat 2015 and 2016. So far, year-to-date 2018 issuance has been relatively subdued and we expect this caution to continue into the second half of 2018; this expectation of limited supply should help to add some support to high yield bond prices.
Figure 8: US corporate high yield new issuance
We know that market sentiment can be volatile, and investor demand can evaporate quickly, so we put considerably more emphasis on credit fundamentals.
Risks
Credit
One potential area of concern is the increasing number of high yield rated US corporates. As S&P noted, after declining from a historical high at the end of 2014, the total number of high yield entities in the US has since risen, reaching 1,791 at the end of December 2017 (see figure below).
Figure 9: US ratings distribution of high yield entities
As at 31 December 2017, of the 1,791 high yield rated entities in the US, 291 were rated B- and 131 were rated CCC+ or lower, for a combined 23.6% of the total. At 23.6%, the share of issuers rated B- or lower is at its highest point in over seven years, having risen quickly since June 2014 after the price of oil started to slide.
Why is this important? From 1981 to 2017, the average annual default rate for entities rated B- and CCC or lower was 8.3% and 28.7%, respectively. So while the average credit quality of the rated high yield universe continues to deteriorate, there is an elevated risk that the default rate may start to rise in the future.
Figure 10: US average default rates by time horizon (1981-2017)
Another concern is the growing wall of debt maturities that corporates will have to refinance, typically by issuing new debt. The figure below shows the maturity profile of the US corporate bond market (excluding financial institutions). In a normal credit environment, there is not usually a problem as investors are generally happy to rollover their capital. However, in a more restrictive credit environment, investors become more cautious and corporates have to pay higher coupon or in a worst case scenario, it may not be able to issue new bonds.
Focussing on the US high yield market, there is nearly USD2.6trn of debt maturing – USD1.6trn of bonds and USD1.0trn of loans in 2019 and 2020, respectively – and over USD5.8trn maturing before the end of 2022.
Figure 11: US corporate bonds maturing
Credit cycle
Noting that all credit cycles are slightly different, it is still worth walking through the different phases in a bit of detail:
- Phase 1 – this usually occurs after a recession or a credit bust. In this phase, management of companies are very focussed on rebuilding balance sheet strength by reducing debt – usually having elevated levels of debt was part of the reason companies may have got into trouble. As the focus is on reducing leverage, it is positive for credit (fundamentals and spreads) but not necessarily equity, as there may be little or no free cash flow available for dividends.
- Phase 2 – financial markets utopia; a bull market! This phase is usually distinguished by strong performance in both credit and equities. Corporate profitability is increasing faster than debt (and leverage), so it is positive for both credit and equities, which are again receiving healthy dividends.
- Phase 3 – the Mature Bull and indicates that the tide is starting to turn. There can be different variations in this phase but generally it is shown by shareholder friendly activity such as M&A, special dividends and/or large share repurchases. To make matters worse for credit investors, these may be largely debt-financed. In this phase, equities typically perform well – ignoring some warning signs in credit markets – but credit starts to come off the boil, manifested in higher leverage and/or wider credit spreads.
- Phase 4 – the bubble bursts. In this final phase, economic growth slows, corporate profitability collapses, and there is a big pullback in bank and capital market investors’ appetite to lend to corporates. This is obviously negative for both credit and equity markets.
Figure 12: Credit cycle
Despite the positive credit fundamentals – corporate leverage appears relatively stable, refinancing risk manageable and access to capital markets is currently good – we are well aware that we are very late in this credit cycle. Historically, credit cycles last about 7-8 years and, if the last meltdown was the GFC, this time we are close to 10 years. This cycle may be slightly longer because of the low interest rates and extraordinary monetary policy used by central banks around the world.
However, we believe that we are getting very close to moving into ‘Phase 4 – Bubble bursts’. Before entering this phase, investors should be looking to de-risk portfolios (see Strategy section below), as both equity and credit markets typically perform poorly.
The dangers of holding lower-rated bonds are shown in the figure below. During the GFC (2007-2009), and to a lesser extent during the fall in the oil price (2015-2016), credit spreads widened. However, it was those weaker credits (CCC and B-rated) that saw the most severe widening. This is highlighted even further in the bottom figure, which plots the difference in spreads between the different rated corporate bonds.
Since the start of 2016, credit spreads have not only tightened but also compressed. As such, investors are currently willing to accept a lower increase in return to move down the credit spectrum – from BBB to BB, BB to B and B to CCC. Given our view that we are close to the next crisis, now is the time to move to the higher ground by adding better quality credits to portfolios to protect against any potential spread blowouts.
Figure 13: Spread compression
Macroeconomic
Despite many leading indicators pointing toward fewer defaults in the near future, several broader macroeconomic risks remain. These include:
- Given current valuations look extended, an equity market correction
- Global geopolitical uncertainties including the recent tension with China, North Korea, Syria, Iran, the ongoing Brexit process and ramification of an anti-euro, anti-establishment coalition in Italy
- The Fed has been raising interest rates and has started to unwind its balance sheet holdings of US Treasuries and mortgage-backed securities; the ECB will cautiously follow the Fed’s path
- There are many potential issues in China: burgeoning credit, excess leverage, higher corporate default rates, and slower than expected growth that would further shock the weak global economy
Strategy
If you believe in the above thesis that we are late in the credit cycle, credit spreads are more likely to widen than compress, and that interest rates will continue to rise, albeit it slowly, then these are some of the generic strategies to consider employing within your fixed income portfolio:
- Investment grade over high yield
- Higher-rated over lower-rated
- Senior over subordinated
- Secured over unsecured
- Short-dated over long-dated
- FRNs over fixed
- RMBS over corporates
- Defensive sectors over cyclical sectors