PMC Weekly Review - May 27, 2016
During our recent Advisor Summit in Chicago, I had the opportunity to host a discussion panel with four distinguished investment professionals to discuss the state of the global credit markets and where the best opportunities lie. This topic was on everyone’s mind in January (when the Summit was being planned), as investment grade and high yield bonds had turned in poor performance for the second half of 2015, and were off to an even worse start in 2016. The subsequent sharp rally in both asset classes from mid-February through the early part of May surely reduced the urgency of the topic, but it remains near the top of the list for many advisors, and certainly for Envestnet | PMC’s research team.
The panel began with a discussion of how the credit cycle is defined and why it is important to have an idea of where in the cycle the market is now. The credit cycle describes the broad fundamentals of companies issuing both investment grade and high yield debt. The trough of the cycle is usually associated with economic recessions, and is underpinned by high levels of leverage, low interest coverage ratios, and a peak in defaults. These increased risks translate to investors reducing their exposure, causing spreads to widen (usually to their widest point in the cycle), which generally limits new issuance, especially in the high yield market.
Companies that survive the trough typically work to de-lever their balance sheets (selling assets or issuing equity to pay down debt) and increase cash flows by delaying capital expenditures. As these efforts begin to show up on quarterly reports, the market moves into the early part of the cycle, and savvy investors begin to add selectively to the most promising companies. The peak in the cycle is characterized by strong fundamentals, cleaner balance sheets, and improving cash flows. This peak is usually associated with the early to middle stages of an economic recovery, but is not generally the point at which spreads are at their tightest. Rather, tight spreads generally are associated with the late part of the cycle, when companies once again become more aggressive with their balance sheets (engaging in LBOs, for example), risk appetite is high, and new issuance peaks. The credit markets then fall back to the trough when the economy weakens, though this late-market condition can exist for several years.
Although our panelists were not all in agreement, they placed the US credit market (as of mid-May) past the peak of the cycle and in the later stages. However, there was a consensus the market could remain in its current stage for some time to come. The option adjusted spread on the Barclays US Corporate High Yield Index stood at 599 basis points as of May 13, and at 556 basis points when the energy sector was excluded. These readings are both above the long-term median of 518 basis points, and are well above the tightest level of 273 basis points in 2007 (before the financial crisis), and the 329 basis points reached in mid-2014 (before the collapse in oil and other commodity prices). Revenues for high yield companies have remained steady, and although leverage has generally increased, interest coverage ratios are near all-time highs because of the very low cost of debt issued since 2009. Defaults have increased over the last year, but they have occurred almost entirely in the commodity sectors. Outside of those sectors, defaults are expected to remain below 2% for 2016. New issuance in the market is still modest, and does not have the high levels of CCC rated debt or aggressive structures that in the past have signaled that a cycle was nearing its end. These combined fundamentals point to an extended runway for the credit markets.
When the panelists were asked to identify where today’s credit market opportunities are, they had a wide variety of answers. Broadly, the conventional high yield bond market was considered to still be undervalued, and for the more aggressive investor, the “survivors” in the energy sector continue to offer significant upside potential even after the recent strong rally. Bank loans were also mentioned as a good opportunity set, though one more diminished than conventional high yield, given the recent rally. Demand for bank loans (and bank loan mutual funds) has been closely tied with expectations for rising rates in recent years. One panelist pointed out they should be considered by investors today not for the floating coupon component, but for the capital gain potential, as much of the market is now trading below par, and is still the most secure part of the capital structure. Another panelist pointed to the European high yield
market and even emerging markets corporate bonds as sources of opportunity. The combination of the European Central Bank’s corporate bond buying program and near zero (or lower) sovereign bond yields for the foreseeable future creates a strong technical backdrop in the Eurozone. EM corporates offer much higher yields than their US or European counterparts, even after accounting for the currency component, creating a strong upside potential as well.
Although there are always risks when investing in any of the global credit markets, generally strong fundamentals and high demand from retail and institutional investors for excess yield have created an environment in which the potential returns, at the very least, compensate for those risks.
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