Practical analysis for investment professionals
09 November 2015

Four Current Opportunities in Credit

Posted In: Fixed Income

What sort of current values are available to credit investors?

Carl L. Eichstaedt, III, CFA, a portfolio manager at Western Asset Management Company, tackled this question at the CFA Institute Fixed-Income Management 2015 Conference on 22 October in Boston. Specifically, he identified four segments of opportunity:

1. US Investment-Grade Bonds

With regard to investment-grade bonds in the United States, Eichstaedt paid particular attention to the widening of credit spreads. In fact, according to Barclays, spreads since mid-2014 have risen by 146 basis points (bps). Eichstaedt attributed this yawn to credit metrics peaking, the tidal wave of new debt issuance, and stormy economic clouds. He characterized the current environment as “mid-late credit cycle.”

Among the specific peaking credit fundamentals he identified were the flattening of revenues and EBITDA of US corporations, as well as increased leverage and cash on balance sheets. Each of these, Eichstaedt said, indicates a bear market that the equity markets have yet to realize. Of course, these fundamental factors also serve to widen credit spreads.

Eichstaedt again referenced Barclays data to make his point about the tsunami of new debt issuance. Between 2012–2014, the gross additional debt hitting markets was $3.3 trillion, with an additional $1.25 trillion expected by the end of 2015, he said. Furthermore, in order to meet new capital standards that require balance sheets to have at least 12% Tier 1 capital (i.e., of the highest quality), financial institutions in the United States have soaked up quality supply and driven down yields. Again, each of these factors serves to widen credit spreads.

Eichstaedt’s advice for those interested in investment-grade bonds boils down to:

  • Avoid industrials, landmines of technology, entertainment and media, pharmaceuticals, and master limited partnerships (MLPs).
  • Sell 10-year maturity credit and buy 30-year maturity credit.

2. US High-Yield Bonds

In the junk bond realm, Eichstaedt showed the audience a chart that appeared to demonstrate a high correlation between changes in credit spreads and changes in default rates from 1984 to the present. A perusal of the graphic indicated a rough presaging of defaults by credit spread widening. If that relationship continues to hold, then it is of particular interest that spreads are widening. Furthermore, Eichstaedt said the current period of low default rates is 54 months old and fast approaching the length of the two most recent periods of low credit defaults, 1995 to late 1999 (58 months), and late 2004 to 2009 (55 months).

Given the above, you might expect Eichstaedt to be bearish on high yield. He pointed out that the leverage coverage ratios are actually on the increase, however, standing at 5.4 times in 2014 versus 3.8 times in 2009. Additionally, debt-to-EBITDA ratios have fallen over the same period, from 5.5 times to 5 times. Interestingly, Eichstaedt pointed out that large, liquid high-yield issues have outperformed in 2015.

What does all of this mean to Eichstaedt? It boils down to two things: Health care is in and energy is out! He also said that the record oil supply is contributing to spread widening. Eichstaedt added that six in 10 energy companies are predicted to go bankrupt over the next several years. He pointed out, however, that fracking wells pay off in about 1.5 years, so if in a depressed energy price environment, companies can immediately cut back their capital expenditures. Hence energy may be oversold.

3. US Bank Loans

Eichstaedt said that bank loans in the form of collateralized loan obligations (CLOs) are inexpensive currently. He based this on the fact that, looked at historically, bank loan default rates are low relative to their spreads. Also, fundamentals are supportive of CLOs according to Eichstaedt. Specifically, EBITDA continues to grow (albeit more slowly), cash-flow coverage ratios are high, and interest coverage ratios are high, too. Leverage levels are neither improving nor worsening, but staying stable. Last, there are limited numbers of near-term maturities which should support a low default rate.

4. Emerging Market Bonds

According to Eichstaedt, historically wider spreads and better credit measures has attracted investors into emerging market bonds. While emerging market spreads vs. developed market spreads are off of their early 2015 highs, they are climbing back up again. Also, for credit grades BBB, BB, and B, emerging market net leverage ratios are actually superior to their developed market peers. Last, current default rates in emerging markets are at historic lows.

In comparing three regions — Asia, Latin America, and Central Europe — Eichstaedt characterizes this as, “Asian corporate debt in ascendance, while LatAm lags.”

Other Interesting Points

Eichstaedt made several asides that also deserve mentioning. For example:

  • He agreed with the overall tenor of the entire conference that market liquidity for most bonds is terrible.
  • A lot of parents are on the hook for student debt that they are not aware of because student loans require their co-sign, and the job market for new college graduates is poor.
  • The biggest buyer of mortgages is still the US Federal Reserve because it is reinvesting the amortizations.

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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.

Image credit: ©iStockphoto.com/Meriel Jane Waissman

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

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