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Late-Cycle Credit Investing
There appears to be growing anxiety among investors that the current credit cycle, now more than 10 years old, is nearing old age and susceptible to a downturn. The implications for high yield credit investors is obvious, as the end of credit cycles tends to coincide with a marked uptick in corporate defaults and asset price corrections.
While we’re mindful we’re closer to the end of the current cycle than the beginning, we see no near-term catalyst to suggest high yield markets are approaching an inflection point. Broadly speaking, credit fundamentals remain sturdy and the technical environment favorable. Corporate revenue and operating profits are strong on the back of healthy economic growth, and defaults continue falling from 2016 highs (Exhibit 1)—all while leverage and interest coverage ratios remain in check or are improving. Additionally, heavy refinancing activity over the last several years has lowered capital costs and extended the maturity of company obligations, reducing the risk of a near-term “maturity wall.” With economic conditions intact and credit fundamentals stable, we expect the current credit cycle to continue and valuations to remain tight over the near term.
We also recognize the current cycle has been longer than most. Yet the excesses that have typically characterized the tops of previous credit cycles have yet to show themselves. For example, nearing the end of the last cycle, aggressive new bond and loan issuance from leveraged buyouts (LBOs), which often accompany credit cycle turns, accounted for more than 42% of new issue proceeds in 2007 and 34% in 2008. Today, LBO issuance remains modest, representing just 19% of year-to-date volume with significant primary market activity focused on refinancing—not leveraging and bondholder-unfriendly transactions (Exhibit 2).
Similarly, today’s high yield market skews higher quality (based on credit ratings) and shorter duration relative to the opportunity set that existed pre-financial crisis. The share of lower-rated bonds in the ICE BofAML US High Yield Index—CCC-rated bonds in particular—has shrunk to an 18-year low, while more speculative issuance is just a fraction of new issuance volume today. Bonds coming to market today rated CCC are just 17% of volume year to date through September 2018—much lower than levels seen in 2007, when CCC issuance reached 38% of total volume. Against this backdrop, it’s not surprising high yield defaults have been modest, and the potential for further spread tightening is not unreasonable when examining the structural differences that have developed over the last decade.
Exhibit 1: Corporate Default Rate
(Note: Par-weighted default rate measures the volume of defaulted bonds by the average principal volume oustatnding for the period under observation.)
Exhibit 2: Aggressive New Issuance Remains in Check
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