Aug 7, 2019, 5:57 PM ETPanel, Conference Presentation

Credit Markets: Back to Neutral?

The credit cycle has been extended for over a decade, with the Fed currently on hold, creating a "benign" environment with GDP growth between 2% and 3%.
The investment-grade corporate market has more than doubled in size since the financial crisis, with the lowest rung (BBB) accounting for nearly 50% of the investment-grade sector.
Single A leverage has increased 250% over the last 10 years, while interest coverage for Single A has dropped from roughly 17x to 12x over the last three years.
Panelists note that the market has shifted from a "bank storage business" to a "buy-side storage business," reducing the speed of market adjustments but increasing the volatility of price movements.
The Fed's pivot in early 2023 reset the credit cycle, leading to a V-shaped recovery where bonds traded lower before quickly rebounding as liquidity concerns eased.

Approximately 50% of the BBB market carries leverage ratios historically associated with the BB (below investment grade) space, a trend panelists attribute to rating agencies enabling these metrics.
Moody's analysis suggests an 18% probability of BBB companies being downgraded into non-investment grade space within a five-year timeline.
Western Asset research indicates a near-term deleveraging trend among the top 25 BBB issuers, with 13 of the top 25 showing lower leverage trajectories and five top issuers explicitly committing to deleveraging.
There is a risk of a "wall of maturities" where low BBBs with long-term maturities drop into the high yield market, creating a "no man's land" where 30-year high yield bonds are difficult to place.
Ann Walsh (Guggenheim) warns that unlike the pre-financial crisis era, the rating agencies may be "rating to an expectation" of future deleveraging which may not materialize in a recession.

Covenant deterioration has accelerated, with 80% of new issues in the last year containing EBITDA add-backs compared to 20% in 2007; these add-backs inflated EBITDA by an average of 45%.
Panelists report that 75% of companies have missed their guidance regarding EBITDA add-backs over the last two years, leading to an unexpected 2-to-1 ratio of bank debt downgrades to upgrades in a strong economy.
Legal maneuvering, such as "collateral stripping" (exemplified by J.Crew), allows sponsors to move assets between capital structure tranches, potentially reducing ultimate recovery rates for lenders.
The "Toys R Us" bankruptcy served as a preview of "zombie companies" that remain afloat due to liquidity despite needing restructuring, resulting in delayed warning signals before default.
There is a growing proposal to standardize covenant quality into numerical scores (1-10) to replace vague "covenant light" labels, allowing lenders to rank private equity sponsors by aggressiveness.

Private credit has seen massive growth as banks reduced their balance sheet retention from 80% pre-crisis to roughly 20% now, shifting the market to a new, less experienced investor base.
A structural mismatch exists in private debt where liquidity options offered to investors exceed the liquidity of the underlying assets, creating a potential "run on the bank" scenario.
The B3 loan market has grown from 2% to 10% of the total loan market over the last three to four years, predominantly driven by Private Equity sponsors seeking easy capital.
Panelists express concern that non-U.S. investors, attracted by the $10 trillion of negative-yielding global assets, are entering the BBB space, creating potential capital flight if market sentiment turns.
Due to the illiquidity and lack of transparency in private markets, funds may face "mark-to-market" difficulties during stress, as seen in the Q4 2018 volatility where loan mutual funds saw an 18% drawdown.

Active managers view current volatility as an opportunity to create alpha, recommending a strategy of holding cash or liquid assets (Treasuries) to deploy during V-shaped sell-offs.
Key risk metrics to monitor include the ratio of LBO and acquisition financing to new issuance; a rise toward 50% (as seen in 2007) signals a 12-to-18-month risk horizon for market distress.
Industry concentration risks are identified as a primary threat, with specific focus on sectors disrupted by Amazon, such as brick-and-mortar retail and supermarkets.
Default rates are currently low, which panelists interpret as a "sell" signal, noting that bubbles are typically created by excesses in risk-taking and leverage.
Forward-looking statements suggest that while spreads may tighten incrementally, investors should expect higher volatility and potentially lower recovery rates in the next downturn due to weakened documentation.
Management teams in the BBB space are increasingly viewed as proactive in deleveraging, with Western Asset predicting a reversal of the leveraging trend over the next four to six quarters.

Regulatory constraints have reduced dealer inventory capacity, forcing broker-dealers to act primarily as "realtors" matching buyers and sellers rather than providing the "speed bumps" or liquidity buffers of the past.
The removal of dealer speed bumps results in faster, more abrupt price movements on the way down and up, as retail and passive funds react to price signals without the stabilizing effect of dealer inventory.
Electronic trading and "all-to-all" trading are expected to increase, further reducing the role of traditional primary dealers in the secondary market.
The presence of passive funds holding high yield and bank loan assets creates a "contagion" risk where technical selling pressure can spread rapidly across asset classes.

During the December 2018 sell-off, bank debt markets fell 4.5 points, but liquidity was maintained as no major funds were unable to service outflows, though retail outflows were substantial.
Panelists identified "leverage" as the single most critical risk metric, specifically corporate over-leverage, which they believe will cause the most pain in the next crisis.
A "canary in the coal mine" for the next crisis is identified as risk-taking at new issuance, specifically the proportion of funds going toward LBOs rather than refinancing existing debt.
One panelist noted that 40 billion in outflows occurred in the first quarter of 2019, representing a significant test of liquidity for the $1.3 trillion high yield market.
Future expectations include a need for active managers to build "alpha" by capitalizing on pockets of volatility, as passive "coupon clipping" becomes insufficient in a tight-spread environment.