Jul 9, 2018, 9:26 PM ETPanel

What's Next in the Hunt for Yield in Credit?

The credit cycle is in its ninth year, with panelists agreeing it is in the "latter innings" but not yet at the end, contrary to late-cycle perceptions.
Factors extending the current cycle include the severity of the 2008 crash (causing conservative balance sheet management), regulatory tailwinds, and tax reform acting as an economic engine.
Investors are cautioned that risk factors have shifted significantly since 2017, with the VIX rising from 9 to 16–17, indicating a move away from the previous "Goldilocks" market environment.
Corporate debt to GDP in the U.S. has reached an all-time high, exceeding 2007 levels and matching 2000–2001 peaks, creating significant refinancing risk over the next two years.
Approximately $4 trillion in U.S. corporate debt is set to mature in the coming years, requiring active refinancing management.

The 2-year to 10-year Treasury yield spread recently narrowed to its tightest level since 2007, and 10-year yields hit 3% (a four-year high), causing the curve to flatten.
Panelists generally dismiss the inverted yield curve as a reliable immediate recession predictor, noting the widening time lag between inversion and recession (from 1.5 years in the 70s/80s to nearly 3 years in 1998/2005).
Acting on yield curve inversions historically results in missed returns; selling the S&P 500 during the 1998 and 2005 inversions would have left 22% and 30% returns on the table, respectively.
The VIX increase to 16–17 is attributed to the Fed's lack of "asset price targeting" compared to the previous Bernanke-Yellen era, which previously dampened volatility.
Market anxiety persists despite economic growth, driven by fears of "mindless" Fed rate hikes and the sheer scale of government debt issuance.

High-yield issuance has slowed due to a lack of pipeline and completed refinancing trades, preventing spreads from widening despite late-cycle concerns.
Investment Grade (IG) issuance has shifted significantly toward the BBB tier (from AAA/AA single-A) as companies optimize balance sheets for tax reform and offshore cash repatriation.
The BBB portion of the high-yield market is at record levels, while the BB portion is near historical highs, creating a compressed spread of only 80 basis points between the two ratings.
M&A activity is expected to pick up, particularly in TMT and energy sectors, driven by tax law changes, the need to fight technological disruption, and the availability of cash-rich strategics.
Leveraged Buyout (LBO) leverage ratios have increased to the 7x–7.5x range, up from the 6x–6.5x norms seen pre-2016.
Equity contributions in LBOs have risen to an average of 40%, suggesting sponsors are making larger equity checks despite higher leverage ratios.
Direct lending portfolios show 60%–70% correlation with private equity, raising concerns about overconcentration and lack of independent credit analysis.

ETF inflows are increasingly concentrated in generic large-cap high-yield bonds, causing those specific issues to become intrinsically rich and creating a crowded trade vulnerable to sudden unwinds.
ETFs have underperformed active management in high yield due to the semi-liquid nature of the asset class and the complexity of capital structures that index tracking cannot fully capture.
Liquidity in the bond market remains fragile; while banks have adapted to Volcker rules, they are no longer providing the same level of proprietary trading liquidity as pre-2008.
Private credit is viewed as a "mixed bag," with direct middle-market lending becoming crowded, while residential lending and non-qualified mortgages offer higher-yield, regulatory-arbitrage opportunities.
Risk in private credit is masked by the lack of mark-to-market pricing, making it difficult to identify deteriorating assets until it is too late.
Institutional investors are increasingly willing to trade liquidity for yield, accepting illiquidity premiums to access asset classes where banks are restricted by regulations.

The panel views the new Fed Chair (Powell) as a continuation of Janet Yellen's dovish tilt, though the market currently prices him as a hawk.
The Fed is expected to be more hesitant and responsive to market conditions rather than adhering strictly to economic models, likely resulting in two rate hikes rather than three this year.
The Fed has shifted away from "asset price targeting," meaning they are less likely to intervene to calm the VIX, potentially increasing volatility but creating alpha opportunities for active managers.
The Treasury will let over $350 billion of securities roll off this year, with an additional $275 billion barrier in fiscal 2019, requiring the investing community to absorb significant funding.
Foreign demand for U.S. bonds is shifting, with Asian bidding slowing due to costly hedging, while some capital is rotating toward European markets for relative yield value.

Investors should avoid generic, highly liquid high-yield names in favor of a bifurcated strategy seeking specific opportunities in litigation claims, liquidation claims, and less trafficked sectors.
Floating-rate loans offer better value than high-yield bonds, yielding close to 7% with lower duration risk and better capital structure seniority.
Constructing portfolios with senior CLO tranches (single A) can provide 4.5%–5% yields with minimal default risk, offset by higher-risk allocations elsewhere.
Active managers should utilize flexibility to move between loans, bonds, different currencies, and jurisdictions to capture dispersion in a market where passive flows are distorting prices.
The asymmetry of leveraged finance remains a key concern; while upside is limited to a few points, downside risk is significant as credit quality deteriorates in specific sectors like cable, telecom, and auto.