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Good morning. Stocks had a break from falling apart yesterday. The S&P 500 closed a bit up. This morning we’ll get the latest CPI data, which will tell us if the crowd predicting peak inflation last month — a whole lot of smart people — got it right. A hot surprise, on the other hand, would give everyone fresh impetus to freak out.
Credit is under pressure, too
Corporate credit markets are starting to tell the same (sad) story as equity markets. Below is the spread over Treasuries for the ICE BofA CCC index, which tracks the lowest-quality publicly traded bond issuers:
Think of spreads as stock prices upside down: as fear rises, they rise too. Until April, they were registering gently rising concern. In the last month or so, they have absolutely shot up. Reassuringly, though, the absolute level of spreads does not look too bad, when viewed in a wider context. Here is the same index going back a decade:
Spreads are still below the levels of pre-coronavirus pandemic 2019, and are less than half of what they were both in the early months of the pandemic and in the 2015-16 credit scare, when $50 oil put many high-yield issuers in the energy industry at risk of default.
Several credit managers told us, however, that as a measure of corporate financial health and risks of default, the level of spreads can deceive. One said that he pays attention to the rate of change of spreads, not the level, since spreads tend to follow long-term trends, and now the trend is going from bad to worse. He sees low but rising spreads as an indicator of the end of an economic expansion, and noted that the Fed’s loan officer survey, which has rolled over and is trending toward tighter lending standards, confirms the signal. Credit is becoming more scarce, and defaults are set to rise. “In the first quarter, credit did badly across the board because rates were rising. Now credit is doing badly because spreads are rising.”
A second credit manager pointed out that the market for bonds in the high-yield index is not particularly deep, and many of the names are all but impossible to borrow to sell short. Even the biggest names are hard to borrow in any volume. So as an indicator of default expectations, he suggested looking at the CDX index instead. It measures the cost to insure high-yield bonds against default. The index is easy to short, allowing investors to express their views fully. Here is what it looks like:
The index is back to the 2015 levels, when the energy credit mess was heating up (though this time around, energy companies are doing great). Until there is more hard data about corporate performance in the new, more difficult environment, the second manager expects credit markets to struggle.
Our colleague Joe Rennison provided another data point last week:
The value of junk bonds trading for 70 cents on the dollar or less, considered a sign of distress and a warning that a company may struggle to repay debts, has climbed to $27bn from about $14bn at the end of 2021, according to FT calculations based on a widely watched index run by Ice Data Services.
A particularly vivid indicator of the change that has taken place is leveraged loans. These are floating-rate instruments most often used to finance M&A. Their payouts grow as rates rise. They overperformed earlier this year as credit investors looked for a haven against higher Treasury yields. They have wavered as markets started to contemplate recession:
When rising rates are the chief concern, floating-rate stuff does well. Not so much when growth and creditworthiness is in question. Worse, some institutional investors have been forced to sell floating-rate winners to cover losses in fixed-rate assets like high-yield bonds, notes Cyrus Moshiri at New Mountain Capital.
How bad is all this? Not that bad, thinks Peter Gleysteen, a credit veteran at AGL Credit Management. Even if things turn sour, he argues, two big cushions protect investors. One is strong nominal revenue growth to cover rising interest expenses. The other, in a default scenario, is capital structures with more equity and less debt than in the financial crisis era, meaning credit investors are more likely to get paid back. He thinks investors should chill out:
Creditors are going to get their money back. As history has proven, including the 2009 recession, if you can be calm, cool, and collected and know what you’re doing, you’re going to be fine. The real impact on the aggregate credit markets from a negative event is the impact on confidence, not its factual, numerical effects.
Matt Mish, credit strategy head at UBS, offers the opposite read. He thinks Fed tightening will rapidly pinch funding conditions — with some firms facing 30 per cent or greater jumps in funding costs — in an already fragile market:
In the start of the Fed hiking cycle, it’s essentially a sweet spot [for leveraged loans] . . . The difference this time is three-fold. One is that the market has a lot of low-quality debt. The second is that the Fed is moving so fast, it’s unlike anything we’ve seen recently . . . . And the last point is [many lowly rated companies in] the B3/B- cohort . . . are loan-only or they’re more dependent on floating-rate structures.
I think the market’s wrong — you’re not going to see the fed funds rate get to 3.25 per cent or above because you’re going to have too much funding stress at the lower-rated end of the loan market.
You will notice that Gleysteen is reassured by equity-heavy capital structures, while Mish is worried about loan-only ones. Part of the disagreement may boil down to the fact that the two analysts watch different companies. As is often the case with credit, no one person has the whole picture. Much of the riskiest lending in this cycle has been done in private markets. We won’t know for sure how vulnerable the market is until something breaks. (Armstrong & Wu)
One good read
More evidence that, rather than reducing fossil fuel investment, the ESG investment movement shifts it around.
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