Thursday, December 20, 2018

Growing turbulence in U.S. corporate credit in 2018 creates future opportunities and risks

Photo: Pixabay/Jan-Mallander

By Daniel H. Clare, Guest Columnist

As we head into the final weeks of 2018, investors have experienced declining performance in large parts of the public U.S. corporate credit markets throughout this year. 

For the year-to-date period through November 30, 2018, the Bloomberg Barclays U.S. Corporate Index, the Bloomberg Barclays U.S. High Yield Index, and the S&P LSTA Leveraged Loan 100 Index generated total returns (in other words, the combination of changes in market prices plus interest payments received) for the period of (-3.9%), 0.1%, and 2.6%, respectively. By contrast, prior to early December 2018 sell-offs in U.S. equities, the S&P 500 Index and the Dow Jones Industrial Average delivered year-to-date total returns of 5.1% and 5.6%, respectively. 

Of note, the greatest weakness experienced to date has been in what are typically considered the “safest” companies, those with “investment-grade” rated debt. This is not entirely surprising given the changes in this market since the Great Recession.  

According to Morgan Stanley, the amount of debt in this market has increased by 142% since 2007, and, since corporate profits have not grown at the same rate, the average leverage levels compared with earnings in these companies has increased by nearly 40% during this period. These issuances have been fueled by low market interest rates due to central bank policies which are now reversing, and, worse, much of the proceeds have left these companies in the form of dividends and share buybacks. Further, despite declines in prices in 2018 (which would increase rates provided to new buyers) and arguably higher levels of risk than historical periods, this debt on average still only provided a 4.4% annual yield to investors as of the end of November 2018.

A future area of risk in U.S. corporate credit that is increasingly gaining attention relates to the “leveraged loan” market, which provides loans to relatively-large (average annual revenues of $3.5 billion) but lower-rated, non-investment grade companies. This market has also grown dramatically since 2007, and, by some measures, is actually riskier than at the peak of the 2007 cycle. For example, according to S&P LCD, so-called “covenant-lite” loans (that is, loans without basic financial maintenance covenants) reached a record high of 79% in 2018, as compared with 25% in 2007, and other lender-friendly protections are also weaker than in 2007. On average, senior debt multiples for large corporate leveraged loans are also higher than in 2007. 

Overall, increasing volatility in the large, traditional U.S. corporate credit markets will create risks and opportunities for pension fund investors. Concerns surrounding the traditional corporate credit markets have also caused pension funds with a longer-term time horizon to look increasingly to opportunities in the private corporate credit markets.  Investment funds in these markets typically provide debt financing to middle-market companies, where, on average, leverage levels are lower, covenant protections are greater, and yields to credit investors are higher. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Constitution Capital Credit Partners or TEXPERS.

Daniel H. Clare
About the Author:

Daniel H. Clare  heads the Constitution Capital Credit Partners team. From 2010 to 2016, he was a managing director at Ascribe Capital, formerly known as American Securities Opportunities Fund. Previously, he was at Diamond Castle, a private equity firm focused on leveraged buyout investments in middle market companies, most recently as a Senior Managing Director. Prior to Diamond Castle, Clare was an investment professional at CSFB Private Equity/DLJ Merchant Banking Partners.

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