Who Will Suffer from a Leveraged Credit Shakeout?
Of all the noteworthy moments from the 2014 CFA Institute Fixed-Income Management Conference, the bombshell may have been the default call from Martin S. Fridson, CFA.
Fridson, CIO at Lehmann Livian Fridson Advisors, has been a leading figure in the high-yield bond market since it was known as the “junk bond” market — and he sees as much as $1.6 trillion in high-yield defaults coming in a surge he expects to begin soon.
“And this is not based on an apocalyptic forecast,” he assured the audience.
High-yield bonds, typically issued with credit ratings at the bottom of the scale, tend to suffer default surges during troughs in the credit cycle. The first high-yield default surge occurred from 1989 to 1992, and encompassed the collapse of Drexel Burnham Lambert. The second surge ran from 1999 to 2003, following the bursting of the dot-com bubble, and the third happened in the midst of the global financial crisis, from 2008 to 2009.
Fridson suggests the next default surge will be larger than the last three combined. Each surge saw an average annual high-yield default rate above 7% (which, if extended over a multi-year period, can add up to real money).
Fridson currently projects that 1,155 issuers will default in the next wave. Over a four-year period that easily surpasses the 644 defaults in 1999–2003, the largest of the three prior default surges.
Fridson: Distressed managers will have "plenty to do" in next cycle; predicts a cumulative HY default rate of 33% in 2016-19. #CFAFI
— Charlie Henneman CFA (@CHenneman) October 16, 2014
For context, Fridson points to the last default surge of 2008–2009: It lasted only two years, and the market swung from a record number of defaults in 2008 to a below-average number in 2009, something Fridson “would have said was impossible.” The reason, of course, was that interventionist policies did as intended in the wake of the financial crisis, cutting the credit cycle short and giving new life to many issuers that were staring default in the face. In the absence of a strong cyclical recovery, this may only have delayed the inevitable.
Fridson noted that since 2010, the high-yield market has seen deterioration in the credit-ratings mix even as it has grown at a compound annual growth rate exceeding 10%, fueled in part by European issuers accessing the high-yield markets in lieu of bank credit, which has been harder to get thanks to more conservative bank capital requirements.
One key assumption behind Fridson’s forecast is that the Fed ends its program of quantitative easing (QE) and allows interest rates to rise. QE may have ended, but Fed guidance calls for interest rates to remain low for a “considerable time.” Fridson was asked about QE and the persistence of low rates during Q&A after his presentation, and the answer left the audience murmuring.
“If we’re in this Fed rescue mode [in 2016–2019], then I think we’re in a lot of trouble. Very serious trouble.”
The final presentation at the Fixed-Income Management Conference was from Paul Travers, a manager of bank loans and collateralized loan obligations (CLOs) at Onex Credit Partners. Travers was quick to offer his thoughts about Fridson’s forecast, which would have a profound impact on the bank loan market if it comes to pass.
“I hope he’s wrong,” Travers exclaimed, noting that high-yield issuers are often also issuers of syndicated loans. “I don’t know if I can live through another four-year default wave.”
In a typical default situation, the holders of senior-secured bank debt would be expected to have much better recoveries than holders of the same issuer’s high-yield bonds, because bank loans have higher priority in the company’s capital structure. But investors in loans may not do as well in the next credit trough as they have in the past, as leverage multiples in the loan market have steadily climbed since 2011.
Unlike fixed-rate high-yield bonds, leveraged loans typically offer floating rates indexed off of Libor, usually resetting monthly, which provides some protection for investors against the prospect of a rising interest rate environment. Travers considers the current credit environment “relatively benign,” and said the current low-rate, low-growth environment is the “sweet spot” for the leveraged loan market — positive growth that isn’t rapid enough to threaten a rate increase. Under these conditions, the S&P/LSTA Leveraged Loan Index par amount outstanding increased to $768 billion in July of this year, adding $76 billion in the first half of 2014.
During his presentation, Travers noted that “Covenant Lite” loans now exceed 50% of the S&P/LSTA Leveraged Loan Index. According to Travers, fewer loan covenants wouldn’t necessarily lead to a higher incidence of defaults, since loan holders in most instances would be inclined to waive covenants rather than force an issuer into default. But over time, the lack of tight covenants could allow cash to flow out of the company, resulting in lower loan recoveries for investors in the event of default.
Of more immediate concern to Travers was the impact of retail fund flows on the leveraged loan market, which had seen 14 consecutive weeks of negative flows at the time of the conference after a long period of inflows. A fairly recent phenomenon in the leveraged-credit market, these retail flows from large loan managers — forced to buy and sell large blocks of loans to put cash to work or meet fund redemptions — contribute to volatility.
In addition to the underlying loan market’s volatility, Travers suggested the CLO market was experiencing volatility itself as a result of just-announced risk retention provisions under section 941 of Dodd–Frank, which would require managers of CLOs to own at least 5% of the risk in their portfolios. Anticipation of this rule was a contributing factor in the rush of CLO issuance in 2014, which equaled 187 deals at the time of the conference.
While the risk-retention requirement isn’t expected to kick in immediately, Travers suggested that going forward, investors should determine whether CLO managers have the capital to comply with this new requirement as part of their due diligence process.
Fridson and Travers approached the leveraged credit market from different perspectives, but their talks suggested that the placid environment encouraged by low interest rates and accommodative credit won’t persist. The next credit cycle will pose some serious challenges for leveraged-credit investors, regardless of their place in the capital structure.
Under the circumstances, the retail component of leveraged credit investments — absent from prior default surges — is probably not a positive development.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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