Amid Rising Risks, Should Investors Maintain Credit Allocations?
Wade O’Brien
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Yes, but investors should be selective in allocating to credit markets at this point in the cycle, and understand that the overvaluation of many credit assets could make attractive returns hard to come by. There are clearly pockets of risk building; for example, lower quality issuance in investment-grade bonds and the weaker documentation favored by leveraged loan issuers. Still, many of the media warnings about soaring debt levels and indiscriminate investors lack context, and some segments of the credit markets remain appealing.
Corporate debt levels are rising, but by less than some statistics would imply. For example, while US non-financial corporate debt to GDP has risen to near record levels, total corporate debt to GDP has fallen meaningfully because financial sector liabilities have shrunk 12% since their pre-crisis peak. Perhaps more important are measures of ability to pay; debt-to-EBITDA ratios for both high-yield and non-financial investment-grade borrowers (4.3x and 2.3x, respectively) have ticked up since the financial crisis but are still close to their long-term averages.
Elevated debt coverage ratios, which compare trailing cash flows with interest expense, provide issuers some cushion should rates continue to rise. Investment-grade coverage (11.6x) is well above its historical average; high-yield coverage (4.0x) also looks comfortable from a historical perspective. These metrics could also improve further as corporate earnings grow (for example, the EBITDA of investment-grade issuers increased by more than 10% in first quarter 2018 compared to the same period in 2017).
Recent reports on surging loan issuance require context. Leveraged loan issuance volumes have hit record levels on a gross basis, but net issuance has been lower, as much of the issuance has represented refinancing or repricing. Yes, the roughly 70% growth of the loan market since the end of 2013 is noteworthy, but less discussed is that the high-yield bond market has hardly grown at all over the same period—in fact, the size of the loan market now exceeds that of high-yield bonds. Some issuance trends suggest demand has been less discriminating; for example, the share of B-rated bonds in the loan index has jumped around 8 percentage points in the last couple of years to 45%. Offsetting this is the declining share of CCC- and non-rated bonds; which means the weighted average rating for the index has changed very little.
But, there are worrying trends in some parts of the credit markets. In the investment-grade space, nearly 50% of outstanding issuance, or $2.4 trillion notional, now carries a BBB rating—creating concerns about the impact on the much smaller high-yield market if a significant volume of downgrades ensues. Around 80% of outstanding leveraged loans are covenant-lite, reducing investor protections by giving companies more freedom in managing their balance sheets more aggressively or selling assets. Last quarter, more than $80 billion (58%) of leveraged loans were issued to fund mergers or acquisitions, a new record. A growing number of borrowers raise funds exclusively via the loan market (or issue bonds that are not subordinate to their loans), removing a traditional layer of protection for loan investors. And finally, the use of so-called “add backs” by some borrowers in calculating EBITDA can mask problems in the underlying business or flatter an aggressive balance sheet.
The curtailment of asset purchases by the Federal Reserve also presents a significant risk for credit markets, and the availability of higher yields on secure assets, such as US Treasuries, may reduce demand from those that had been pushed into riskier corners of credit by abnormally low interest rates. Meanwhile, the combination of expected Fed rate hikes and the need for more Treasury issuance to finance growing budget deficits could also push yields higher, suggesting caution around long-duration assets is warranted.
Most credit spreads and yields have drifted higher in 2018, but some may not offer sufficient compensation for the risks flagged above. Current spreads for investment-grade bonds and leveraged loans are around the 40th percentile of their historical range, while high-yield bonds look more expensive. Within higher-beta credit, we favor more attractively priced asset-backed securities, as well as selective private credit strategies including specialty finance and more flexible credit opportunity funds. Such assets will offer diversification and, in many cases current income, though they could fail to keep pace if equity valuations continue to rise. Meanwhile, although yields have risen, the declining quality of investment-grade bonds means they should not be relied upon to provide safe harbor in a storm.
Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research Team.
Originally published on August 7, 2018 This report is provided for informational purposes only. The information presented is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Some of the data contained herein or on which the research is based is current public information that CA considers reliable, but CA does not represent it as accurate or complete, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax or legal advice. Past performance is not indicative of future performance. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.