Earlier today, the FT wrote an article in which it found that "companies have defaulted on $78bn worth of debt so far this year, according to Standard & Poor’s, with 2015 set to finish with the highest number of worldwide defaults since 2009" which together with a chart we have been showing for the past year, namely the staggering disconnect between junk bond yields and the S&P500...
... has made many wonder if the credit cycle - a key leading indicator to economic inflection points and in the case of the last credit bubble, the Great Financial Crisis - has already turned. According to a recent analysis by Ellington Management, the answer is a resounding yes.
Below, we present what Ellington believes are the 4 telltale sings the credit cycle is turning now. The full report is a must read for everyone (link here) but for those who wish to know where the overall debt market is headed, the below excerpt is a must read, especially since as Ellington concludes, once "fickle investors exit the market, high yield bonds and leveraged loan prices should settle at a supply/demand equilibrium well below today's levels."
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Telltale Signs the Credit Cycle is Turning Now
We believe that we are now at the end of the "over-investment" phase of the corporate credit cycle in the US that has been playing out since the depths of the GFC. This view is supported by a number of telltale signs of a reversal in the credit cycle:
- Worsening Fundamentals - Declining corporate prots, record levels of corporate leverage, and an elevated high yield share of total corporate debt issuance
- Defaults/Downgrades - Credit rating downgrades at a pace not seen since 2009
- Falling Asset Prices - Price deterioration in the lowest quality loans and the most junior CLO tranches
- Tightening Lending Standards - Weak investor appetite for new distressed debt issues, declines in CLO and CCC HY bond issuance, and tightening in domestic bank lending standards
The turn of the credit cycle from expansion to contraction tends to play out the same way each time. Initial enthusiasm about a new technology, innovation, or policy change creates an investment boom and easier lending standards. This virtuous cycle repeats itself, with stronger fundamentals, lower volatility, and higher leverage. Financial markets facilitate increased leverage, magnifying booms and busts. Return-chasing investors pile in, fueling more debt issuance. Borrowers who would have otherwise defaulted are able to refinance as leverage increases faster than cash flows deteriorate. Over-investment inevitably leads to loans that go sour, and as the tide of leverage goes out, the full extent of irresponsible lending becomes apparent. The previously virtuous cycle between risk spreads and fundamentals goes into reverse, with lower prices, defaults, and downgrades forcing leveraged investors to sell, leading to even lower prices.
As we have shown, the demand for high yield assets today is fickle. Once these fickle investors exit the market, high yield bonds and leveraged loan prices should settle at a supply/demand equilibrium well below today's levels.
Telltale Sign #1: Worsening Fundamentals
As we noted earlier, corporations are now running out of steam in terms of their ability to generate earnings. As of Q2 2015, the year-over-year change in annual corporate earnings dropped to -$8.21 per share for the S&P 500 and to -$4.79 per share for the Russell 2000. The previous three times this metric fell that far into negative territory on the S&P 500 were Q1 1990, Q1 2001, and Q4 2007, coinciding with the start of each of the last three high yield default cycles. According to a recent article in The Economist, in the most recent quarter less than half of S&P 500 companies recorded increasing prots year-over-year.
The average quality of corporate debt issuance has also deteriorated in the past few years. Recent research documents a strong link between issuer quality in corporate debt markets and excess returns over the following 1-3 years. This empirical finding holds when credit quality is measured both in terms of credit spreads (market implied default probability) as well as credit ratings. Our research suggests the lag may be slightly longer, with high HY issuance fractions in 1996-1998 and 2003-2004 being followed by default waves in 2000-2003 and 2009-2011. Again, we believe that the root cause of lower issuer quality in recent years is lower interest rates. First, as central banks have purchased massive amounts government bonds and MBS, they push investors into risky assets that they would not otherwise buy. Second, a declining interest rate environment is helpful to corporate balance sheets, thus creating the illusion that lower default rates are evidence of improving corporate fundamentals.
Since 2010, the HY fraction of total corporate debt issuance has been at or above levels that preceded the last two waves of corporate credit defaults (see Figure 11 below). What is remarkable about today's high HY fraction of debt issuance is not only its level but also its persistence. Unlike the past corporate credit booms of 1997-1999 and 2003-2005, HY companies have faced a very friendly environment of zero short-term borrowing rates and declining long-term interest rates. This has made the most recent credit cycle more extreme and of longer duration than past cycles. Moreover, because the relationship we document between the HY fraction of issuance and future returns has been during a declining rate environment, the predicted excess return over Treasuries is even lower on a duration-adjusted basis.
Telltale Sign #2: Defaults/Downgrades
Many credit investors have mandates to invest only in bonds with minimum ratings provided by the rating agencies. S&P issued 108 downgrades for US non-financial companies in August and September and 297 downgrades YTD, the most in a two-month period since May-June 2009 and the most in a year since 2009.
Downgrades create a perverse supply problem for high yield. Even if issuance were to shut down, downgrades from investment grade to high yield and from high yield to distressed create net new supply in the lower tier sectors. This is relevant because the investors who play in the high yield and investment grade debt markets are two largely disjointed groups. Since there is a lot more investment grade paper outstanding than high yield, downgrades could potentially present even more of a supply issue for the high yield market than high yield issuance.
Ratings downgrades can have immediate impacts on securitized debt as CLOs and other products have ratings provisions that determine how cash flows are allocated to different investors in a securitization. For example, ratings downgrades can shut off payments to the bottom of the capital structure of many CLOs. The size limit on loans rated CCC and below is typically 7.5%. The average CLO exposure to CCC and below is currently up to 4.3% from 2.3% two years ago, while the fraction of CLO holdings just one notch above CCC has remained around 20-25% since 2009.14 If only a fraction of these near-CCC holdings is downgraded, the 7.5% limit will be exceeded, which will trigger a haircut to be applied to the collateral for the purpose of overcollateralization (OC) tests. Once a CLO fails the OC tests, cash flows are diverted away from equityholders.
Because CLOs now absorb 70% of leveraged loan demand, the pricing of par loans will experience a quantum jump down to a new equilibrium level if 70% of demand is taken away. Not only will a halt in CLO issuance lead to a drop in leveraged loan demand, it will also create short-term supply pressures from liquidations of CLO warehouses for deals that did not get done. A number of CLO warehouses are significantly underwater today. We expect to see selling pressure from these warehouses as we approach year-end, especially given the pricing pressure on leveraged loans that has persisted since August. We saw the same dynamics when the ABSCDO and CLO markets shut down abruptly during the GFC
Telltale Sign #3: Falling Asset Prices
Late last year, the first cracks in the high yield edifice began to show with the decline in oil prices. This led to a decline in high yield bond prices, but losses were contained mostly to the Energy sector. As concerns about China weakness intensified this past summer, Metals & Mining also began to feel the heat. However, as Figure 14 shows, while the returns in the Oil & Gas and Basic Materials sectors (the latter of which includes Metals & Mining) have been disastrous over the past year, the rest of the HY bond market is actually up YTD. Moreover, the relative decline in Oil & Gas and Basic Materials has been a slow bleed on a beta-adjusted basis versus the whole sector. While we have seen market jitters, contagion in HY has yet to really extend beyond industries directly impacted by lower oil prices.
One can tell the same story with distressed versus non-distressed high yield sectors. Figure 15 shows the cumulative performance of the S&P US High Yield Corporate Bond Index versus the S&P US Distressed High Yield Corporate Bond Index. Again, the effects of initial fundamental weakness among the most distressed high yield borrowers have not yet percolated up to stronger credits. This suggests to us that it is not too late to get out now.
It is not just Energy and Basic Materials names that are contributing to poor distressed returns today. As Table 1 shows, in 2015 most distressed industry groups are seeing underperformance versus high yield.
Individual sector weakness may at first seem like an isolated issue. However, the contagion process has already been set in motion as the riskiest segments of high yield now trade at multi-year wides. Investors in these assets include distressed investors, leveraged buyers of junior credit index and bespoke tranches, CLO mezz and equity investors, and buyers of new issue Energy sector debt this past spring. Not only are the most leveraged sectors usually the first to crack, but the most leveraged investors tend to have greatest exposure to these sectors. As these investors de-lever, price pressures induce the next round of deleveraging in a negative feedback loop.
As shown in Figure 16, spreads on more senior new-issue CLO tranches (AAA through A) are below their recent trailing averages, while riskier new-issue tranches (BB through B) have widened substantially since July. The same divergence can be observed in the high yield bond market in Figure 17, where lower rated CCC collateral has widened versus B-rated collateral to levels not seen since the GFC.
Telltale Sign #4: Tightening Lending Standards
The marginal buyers in credit markets are the ones who set underwriting standards. Their losses mean that credit conditions are already tightening, and this resetting of underwriting standards is consistent with the high number of deals pulled in October. More generally, cov-lite deals are much harder to get done now. A number of new deals are being done, but with lower fees and wider spreads on the junior mezz tranches.
As loan issuance has declined, so have the prospects for M&A among the riskiest borrowers. In recent months, banks that extended loans to high yield companies to finance buyouts are now unable to sell those loans to investors, who have become skittish about the worst quality high yield debt. We are seeing the immediate effects of this lack of a bid as banks who hold these loans on balance sheet must sell them by year-end in order to avoid significant capital charges, resulting in forced sales at a loss. The risk-averse behaviors of banks since the GFC suggest to us that banks will be much less inclined to underwrite risky deals going forward after suffering such losses.
Recent trends in bank lending standards for corporate loans also demonstrate that tightening is underway, and this has historically been a strong predictor of high yield corporate default rates. As shown in Figure 18 below, there has been an 89% correlation over the past 25 years between changes in bank lending standards and speculative grade corporate defaults a year forward. This predictive relationship is strongly statistically signicant, even after controlling for lagged default rates. This 89% correlation is much higher than the contemporaneous correlation of 62% between the two measures, suggesting that tightening lending standards drive defaults higher. In the third quarter of 2015, a net 7.4% of banks tightened lending standards for commercial and industrial loans, the tightest reading since 2009. While today's tightening in lending standards looks somewhat similar to that in 2011, that blip was more of a head-fake from the Euro crisis, and was therefore a short-term period of uncertainty originating from outside the corporate credit markets, compared to today's tightening where the major source of lender uncertainty is coming from corporate credit itself.
The predictive power of changes in lending standards suggests that tightening lending standards directly impact future default rates, as companies have difficulty rolling over debt. This demonstrates the mechanism by which contagion spreads from a few isolated sectors to all of high yield. As a few sectors underperform, banks experience write-downs and losses, which leads them to tighten overall lending standards. This leads to broader weakness, perpetuating a feedback loop that triggers a default cycle. An imminent Fed hiking cycle today is yet another reason to expect bank lending standards to continue to tighten.
Deteriorating corporate fundamentals would be less of a concern in the short run if investors chose to ignore the fundamentals, but our distressed loan traders have been seeing the opposite. Investor appetite for risky loans has fallen off a cliff. We give four examples from the distressed sector, followed by some sobering statistics from the CLO market.
First, Millennium Labs' leveraged loan was trading at par in April. The loan fell to $50 in June following allegations that the company was defrauding the government and would have to pay a fine of unknown magnitude. The loan facility is relatively large, at $1.775B in size. A few weeks ago, a block of $20 million (1% of total issuance) became available. Market chatter was around a price of $35 (30% below the market level at the time), for a total of $7 million in proceeds. Even at this steep discount, the block did not clear as the sourcing desk could not find enough buyers.
Second, recent new issues in October have priced very wide to talk or have been pulled altogether. Four deals were pulled in October alone, including SiteOne, Xerium Technologies, Apple Leisure Group, and ABB Optical Group. Other deals are coming out very wide relative to price talk. Fullbeauty Brands had two term loans price recently, with initial talk at $99 and L+450 for an $820 million first lien, and $98 and L+850 for the second lien. These two loans ended up pricing at $93 and L+475 and $87 and L+900, respectively (the latter at a 13.2% yield!). In each of these cases, the banks syndicating these loan transactions were stung
with losses on the loans. Even for deals that eventually clear, banks have been quick to respond to such losses by tightening terms for new issues.
Third, we see weak investor appetite in combination with financial that appear to be managed to slide in just under the radar of regulatory scrutiny. Builders First Source came to market with a deal in April 2015 that was exactly 6.0x Debt/EBITDA, using a pro-forma EBITDA methodology that contained numerous add-backs, which added around $50 million to arrive at a final EBITDA number of $376 million. Excluding these add-backs, leverage would have been at 6.9x, above the 6.0x maximum level that the Federal Reserve and the OCC deemed to be prudent underwriting standards.
Fourth, on September 15th, Moody's downgraded Sprint's senior unsecured debt from B2 to Caa1. Fears of downgrades by the other rating agencies to CCC, which would impact portfolio managers' CCC concentration limits, drove pricing on Sprint's $2.5 billion of bonds maturing in 2028 from $88.40 the day before the downgrade to $80.80 two days later. Being one of the largest names in the high yield universe with $30 billion in total debt outstanding, this price shock was felt across debt markets. While prices eventually recovered, such large price swings on a single ratings downgrade show the extent to which investors have been willing to sell debt at the first signs of trouble.
Adding to this anecdotal evidence, there is an overall trend this year of declining issuance in lower-rated US HY corporate credit. As shown in Figure 19 below, total US CCC issuance this year stands at $30B on an annualized basis as of the end of October, down 48% from its peak of $58B in 2013. In contrast, overall US HY corporate debt issuance has fallen only 16% over the same period.
The CLO market has also exhibited recent signs of weakness on both the supply and demand side. In terms of supply, leveraged loan issuance is down more than a third year over year and since June, and the rate of US CLO issuance has fallen to half the 2014 rate (Figure 20). Pricing on new-issue CLO equity has weakened substantially given the weakness in high yield Energy, Metals & Mining, and Power/Utilities. Weakness in one sector is enough to make equity and BB tranches risky enough to lack a bid, which should impair CLO issuance.