Monday, February 24, 2020

Investment Insights

The next credit cycle


Graphic by Deedster from www.pixabay.com.

by Bruce Richards and Louis Hanover/Guest Contributors

The corporate credit markets have evolved over the past decade in a way that has created pitfalls that will likely materialize when the credit cycle turns negative or a recession occurs. We expect that the corporate credit markets will behave differently during the next credit cycle than they have during previous cycles. 

In our recent thought-piece, we present key themes of today’s corporate credit markets for investors to consider when preparing for the next downturn. While the evolution of corporate credit markets since the last recession has introduced plenty of downside risks to various credit investments, it will also lead to a tremendous opportunity to deploy capital and realize outsized returns for patient investors who are truly opportunistic.

The U.S. economy is enjoying its longest expansion in the post-war era. As concerns regarding slowing growth accumulated, the Federal Reserve eased rates three times in 2019. Corporate earnings have softened in recent quarters, despite a healthy U.S. consumer and job growth. A reduction in consumer leverage has been driven by strong employment, wage gains and improving balance sheets given the stability in housing prices. 

In fact, despite the U.S. economy growing by approximately 47% since the last recession (from $14.6 to $21.5 trillion), total household debt has grown by only 10% (from $12.7 to $14.0 trillion) and housing related debt has shrunk by 2% (from $10.0 to $9.8 trillion). Conversely, BBB-rated and high yield companies carry record levels of leverage. Consequently, we believe the effects of an economic and credit downturn will be much different from those felt during the last cycle, with a greater impact on these debt-laden companies, while the U.S. consumer will likely perform relatively well.

We do not forecast the timing or magnitude of the next recession. Our focus is to outline the dynamics that have changed since the last recession and will impact the corporate credit markets in the next economic downturn. We highlight the following key themes: 
  • Liquidity will be the greatest risk
  • Rating agencies, behind the curve
  • Covenant protections have disappeared
  • Default rates expected to peak at a lower level compared to prior cycles
  • Recovery rates are expected to be lower
  • Leverage ratios are considerably higher
  • Senior bank loans have absorbed junior debt
  • Pro-forma adjustments and add-backs are misleading
  • The use of unrestricted subsidiaries for asset transfers
  • Middle market direct lending has surged
  • Corporate credit issuance has soared
  • BBBs: unprecedented growth
  • Credit has become extremely bifurcated
In our recent whitepaper, we discuss many key themes and important differences that investors should focus on as we enter the next phase of the corporate credit cycle. 

Significantly weaker liquidity, massive growth of the high yield market and the confluence of structural changes that have occurred since the 2008 crisis lead us to believe that there will be a record amount of fallen angels and corporate distress across a diverse set of industries in the coming credit cycle. As a result, investors should prepare for when the corporate credit cycle turns. Historically, distressed cycles have occurred infrequently. You only get one bite of this apple once a decade, so don’t miss it, be prepared, timing is everything.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Marathon Asset Management or TEXPERS, and are subject to revision over time.

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