Practical analysis for investment professionals
02 December 2015

The Credit Markets Are Softening and Funding Is Tightening

Posted In: Fixed Income

There are ominous things happening in the credit markets, and investors are becoming increasingly concerned. To the casual observer of markets, these signs are probably less apparent because there has been a growing disconnect between credit and equities. Since the end of the third quarter, equities have rallied while credit has lagged.

Many have probably heard that high-yield bonds have struggled, but the general narrative from this crowd has been that this softness is primarily due to energy credits. This makes sense. The energy sector of the high-yield market, via the Barclays cash credit index, has produced a negative 13.2% year-to-date return. Excluding energy, the high-yield market has fallen 0.37% year to date.

But dig a little deeper below the surface and a different picture emerges. The composition within lower rated credit has performed much differently. The lowest rated credits have dramatically underperformed higher rated non-investment-grade credits. Moreover, the concerns go beyond high yield and the loan market.

What is happening is the opposite of what we’ve seen in the past few years during the peak of the chasing yield environment, when the lowest rated credits outperformed, aided by investors’ lust for yield.

For instance, Barclays noted, “The spread between BB and B loans is at four-year wides. In high yield, CCC returns are now -6.3% on the year.” The struggles of the loan markets have fed into collateralized loan obligation (CLO) performance. As shown in the following charts, spreads on BB rated CLO tranches have widened substantially:

So, where do we go from here? One might reasonably say that this situation provides a buying opportunity for yield-starved investors.

From a fundamental point of view, this argument has some merit because, overall, leverage levels aren’t egregious and interest coverage ratios are close to all-time highs.

From a technical perspective, I would argue things aren’t so rosy. Fund outflows have picked up speed, risk-retention rules loom for the CLO space, and investors are pondering the impact of a potential federal funds rate hike.

Other Credit Areas Struggle

The securitized credit space has also seen pressures. Less liquid segments of the asset-backed security (ABS) market, such as whole business securitizations, have struggled in recent months and have traded down substantially.

Large spread widening also took place within the non-guaranteed portions (B tranches within Freddie K deals) of Freddie Mac’s multifamily securitizations. A similar situation is occurring within non-agency mortgage-backed securities (MBS) and non-agency commercial mortgage-backed securities (CMBS).

Concerns are growing among fund managers whom I speak to. Looking forward, they are saving dry powder for much lower levels than where bonds are currently marked. This is critical because the marginal bid for lower rated assets isn’t a point or two lower, but rather “much lower.”

Repo Costs Rising

Perhaps the most troubling sign (and biggest overall wildcard) is that we’ve seen repo costs rise.

Hedge funds and other investors often use repos (repurchase agreements) as a way to leverage and enhance income/returns. Anecdotally, it seems that one-month repo terms have stayed steady, while two-month and longer terms have risen 20-plus basis points (bps) over the last few months. The fallout from higher funding costs can end up having a chain reaction that can lead to further pain in the credit markets.

Higher repo costs can cause leveraged investors to reduce leverage by selling bonds. Given that the bonds being leveraged are the ones with widening spreads, the additional supply of bonds on the market can cause additional pressure on prices. This can end up being a vicious cycle, where selling pressure causes lower prices and lower prices precipitate the need for more deleveraging.

It’s difficult to tell whether the cost of funding is rising because of a potential rate hike or in response to concerns over too much leverage and a softening credit market. Nonetheless, a trend of higher repo costs could have major ramifications in the credit markets, as described here. In a low-yield environment, investors have relied heavily on leveraging lower rated credit to hit various yield hurdles. The apparent rise in funding costs and loss in investor appetite for the junkiest types of credit portends a potentially difficult situation.

While it is too soon to panic, there are enough signs that bear very close watching in the coming months.

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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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About the Author(s)
David Schawel, CFA

David Schawel, CFA, is a portfolio manager for New River Investments in the Raleigh/Durham, North Carolina area. Previously, he managed a $2-billion fixed-income portfolio for Square 1 Financial, which he joined in 2008.

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