Expensive credit markets

Rory Maguire - Fundhouse

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Published: 20th January 2021

This Article was Written by: Rory Maguire - Fundhouse


Lending money to both investment grade and high yield companies (globally) looks likely to lead to poor long-term returns.

If starting real yields are a guide, as they have been historically, returns could well be the lowest on record. Yet markets are as optimistic as they have ever been, at a time when corporate fundamentals are under pressure and issuance is at all-time highs.  Extraordinarily low yields juxtaposed with these heightened corporate risks suggests negative real returns from these levels. In the history of providing asset allocation advice to clients, we have not been as negative on corporate debt as we are today. Why?

  • Real yields are close to all-time lows suggesting investors see very few risks ahead. In our estimations, you are being paid around 0.8% real yield on investment grade and 3% on high yield, at a time when inflation is almost absent. Both are well below long-term averages. In the US, for example, real yields on investment grade debt went negative for the first time in December 2020.
  • Actual yields are at all-time lows indicating that bonds are probably offering the lowest prospective returns ever. Spreads (to cash and government bonds) are now below average too, even when short-term interest rates are close to zero. Who would have thought that on a spread basis (relative to history), 10-year US Treasuries at 1% look more attractive than both US IG and US HY?
  • Corporate fundamentals have deteriorated. Companies have become more indebted, corporate earnings are low, cashflows are under pressure and defaults are increasing. In 2020 as the impact of Covid-19 played out, companies borrowed record amounts (corporate bonds and syndicated loans), pushing up leverage ratios. Compared to 2014, we see 40% more debt on corporate balance sheets today. We are also seeing lowering of free cashflow rates through 2020, in spite of the dividend cuts. Lastly, we note how banks are predicting higher default rates than credit markets, which is rare.
  • Long-term default rates are not being priced in. According to Moody’s Investors Service, the U.S. trailing 12-month high-yield default rate jumped from 4.1% in November 2019 to 8.4% in November 2020 and may peak close to its expected 9.5% average for 2021’s first quarter. However, current yields on HY are half of this today (just over 4%).  In fact, from our records, the long-term default rate for US HY is 3-4%, on par with current yields. The mass issuance has pushed out the maturity wall, which is quite helpful, with only around 8% of debt due in 2022 (according to Fitch), so we may well see some delays in defaults because of this.
  • The quality of IG issuance has reduced, and duration has increased. Unlike HY, the largest sector is banking, at almost 25% and maturities are far longer, averaging 7-10 years, and over 15% are at 20+ years until maturity. We also find the largest issuances are to BBB (50-55% or so of indices) and the bulk of the difference is A-rated.  10 years ago, BBBs were around 37% of the market and their allocation is now 55%, suggesting the index is riskier today.  Duration on investment grade issuance has also increased and, from what we can see, is at all-time highs. Spreads should be higher, not lower, compared to history.
  • The US 10-year is on the rise. With bond markets pricing in inflation and the prospect of rising interest rates, refinancing costs will grow and defaults may increase.
  • Liquidity is all but forgotten.  Lest we forget the liquidity crisis of March 2020, when we saw spreads move out at a speed not seen before. Banks are no longer the providers of corporate liquidity they once were. Yes, central banks are now actively buying bonds, which helps in the near term, but high yield does not have the same degree of liquidity support, with central banks only buying some ETFs and fallen angels.

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