UBS' chief global credit strategist Matthew Mish has been on a roll lately. After first revealing "how the investment grade dominos will fall" in mid January (an analysis which was followed by another leg lower in IG bond prices), and then two weeks later instead of focusing on products, Mish analyzed sectors and explained "What's The Next 'Energy' Sector In Credit Markets", today he tries to put it all together and as he himself puts it, "the inquiries we have received are increasingly from investors across all asset classes and regions, and lines of questioning evolve in many directions. But the genesis of the debate comes down to three questions: first, why is the sell-off happening; second, when does it end; and third, what can slow or speed up the process?"
We are certain that these are the questions asked by every single credit investor, so without further ado, here are Mish's answers.
What is the clearing level for $1tn in stressed credit?
First, why are HY credit markets wilting? For non-credit investors the simple analogy is a balloon. The air going into the balloon was essentially inflows into credit funds. Our prior work suggests inflows have been driven by three factors: quantitative easing, credit losses and past performance. From 2010-2014 the environment was extraordinary; at its peak, the Fed was buying roughly $1tn annually in fixed income securities, crowding investors into corporate credit; defaults were low as capital markets were accessible and earnings were expanding, and prior HY returns were unprecedented. The money poured in, and credit funds put that cash to work. However, that mirage has faded; the Fed is tightening policy, defaults are rising due to commodity price declines and excessive leverage, and past performance has been negative. Outflows are triggering forced selling across real money and hedge funds.
However, the problem is not simply technical. The root cause is fundamental in nature. During that period of euphoria, credit portfolio managers were essentially forced to buy the market. The inflows were too robust. In that environment, fundamental credit analysis became secondary. Clients had yield targets to achieve, and with central banks pushing interest rates towards zero those that bought high grade credit in prior decades bought high yield; those who purchased high yield previously bought triple Cs. Unfortunately, investors were being compensated in a fairly linear fashion across IG, HY and CCCs. Later in this period a few hundred basis points was the yield differential between IG versus HY and HY versus CCCs (Figure 1). But realized defaults increase at an exponential rate when one moves from IG (Aa, A, Baa) to HY (Ba, B, Caa, Figure 2).
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Second, when does the credit sell-off end? Unfortunately, we believe the answer to this question is complicated – complicated in that traditional models may not provide a perfect guide. Models always work better in than out-ofsample, but model risks increase when there is a structural or paradigm shift. In the current environment, there are at least two possibilities. First, the level of dispersion in US high yield between commodity and non-commodity industries is quite extreme by historical standards. Second, the lower quality segment of the high yield (and all leveraged credit markets) is undergoing a structural shift in that the proverbial balloon is no longer inflating, but deflating. Capital is wounded and illiquidity is complicating an exit as the saying goes 'fool me once, shame on you; fool me twice, shame on me'. A new marginal buyer is needed. And the overwhelming majority of potential new buyers we speak with are fundamentally pricing lower quality risk through the cycle (or restructuring process) and under the assumption this debt is illiquid.
In our 2016 US high yield outlook we posited there is one central question that will dictate the outlook for high yield: will credit markets be able to absorb refinancing needs of almost $1tn stressed and distressed credit. And we continue to believe this should be THE debate in the market. In our view, if the lower quality rung of the market cannot stabilize the balance of risks is for contagion to spread further. So what is the clearing level for what we believe is upwards of $750 - 1tn in stressed credit? First, investors will require compensation for loss risks; cohorts of triple Cs typically experience 5yr cumulative default rates of 55 - 65% near the end of the cycle, implying half of the universe defaults before the end of year 5 and no longer pay coupons. Assuming recovery rates of 35% an investor should require roughly 12% yield to compensate for loss risks alone. What about mark-to-market and liquidity risks? While triple C bonds are trading on average in the low $60s, investors will likely need to stomach a further decline later in the cycle. Historically, triple C prices bottomed in the $40 – 50 range, so potential MTM declines could be significant (Figure 3).
Further, although our prior analysis assumes hold-to-maturity, investors will need to be compensated for the fact that illiquidity may prevent them from selling when needed. Bottom line, our conversations with investors suggest yields in the 20 – 25% context could be attractive enough to draw in marginal capital – although several investors noted that is reasonable for triple C risk excluding commodities. In short, we're not there yet.
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Third, what reverses or speeds up the process? We would reiterate the primary drivers of fund flows are credit fundamentals and central bank policy. Higher commodity prices would ease, albeit not remove, default concerns. Better-than-expected earnings could also help sustain excess leverage on corporate balance sheets. And aggressive monetary policy – that which could conceivably push investors back into lower rated credit – could extend the cycle. And the reverse is also true in both cases.