Panel
What's Next in the Hunt for Yield in Credit?
Milken InstituteJustin Baer, Michael Buchanan, Robert Kricheff, AJ Murphy, Fred Orlan, Christian Stracke, Mike Buchanan
- The credit cycle is expected to extend further due to the lingering effects of the 2008 crisis severity, regulatory tailwinds, and tax reform, with no current signs that the cycle is nearing its conclusion.
- Fundamental risks require a catalyst to materialize into deterioration, though market prices have not yet adjusted to reflect significantly higher risk factors present in the current environment.
- Issuers are in the late stages of the credit cycle regarding leverage structures, with LBO leverage caps rising from pre-Trump levels of six to six-and-a-half times to current levels of seven to seven-and-a-half times.
- Credit markets are viewed as being in the latter innings without having reached the end, characterized by an asymmetric risk-reward profile where downside potential significantly outweighs upside.
- The high-yield market is becoming bifurcated and may not improve from current states even if fundamentals shift, with new M&A pipeline changes potentially causing spreads to widen orderly.
- Corporate debt to GDP in the United States has reached an all-time high exceeding 2007 levels, and refinancing trades are largely complete, leaving M&A as the primary growth driver.
- Tax reform is anticipated to act as a tailwind by increasing cash flow, driving more M&A activity, and causing a migration of investment-grade credit toward triple-B and high-yield toward double-B or higher quality structures.
- Private credit sectors face risks from overcrowding in direct middle-market lending, a potential bubble in fund creation driven by liquidity-yield trades, and reduced information transparency similar to opaque assets.
- Investment-grade market dynamics include a stock of refinancing risk, with new issue spreads tightening from negative territory to 10–15 basis points, while the overall IG market outperforms high yield by 10 to 15 points year-to-date.
- Market liquidity structures have shifted due to the Volcker Rule, resulting in a decline in bank-owned hedge fund liquidity and a transfer of risk from daily trading liquidity to bridge loan risk.
- The Federal Reserve is no longer accommodative and is removing support, with expectations of fewer than three rate hikes this year and a reaction more driven by market signals than previous models.
- Treasury funding needs involve over $350 billion in securities rolling off this year and another $275 billion in fiscal 2019, requiring the investing community to absorb significant heavy lifting.
- Global capital flows are shifting as Asian bids for U.S. bonds slow due to hedging costs, while liquidity moves toward European markets where currency trading offers more value.
- Specific opportunities exist in private credit areas such as residential, commercial real estate, and consumer lending, though generic large-cap high-yield bonds are considered overly rich and crowded.
- Investors are advised to seek value in the loan market over high-yield bonds due to better duration, capital structure, and relative yields, with potential portfolio constructions targeting 4.5% to 5% yields or 15% returns through litigation and liquidation claims.
- Economic growth presents a dual risk where rates moving higher due to strong growth or perceived late-cycle concerns due to slowing growth both negatively impact the market.