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.

About the Authors:

A Case for ESG Investing in Texas Public Plans

ESG Investing has Seen a Rapid Growth in Assets Over the Last Few Years

Pension Review Board Adds New Reporting Rules to Texas Administrative Code

Joe Gimenez/Photo

Christopher Zook, second from left, listens during a Feb. 6 meeting of the Texas Pension Review Board.

By Joe Gimenez/Guest Contributor

During its Feb. 6 meeting, the Texas Pension Review Board followed through on legislative bills passed last year by adding rules to the Texas Administrative Code for the reporting of investment fees. The Board also adopted staff proposals for categorizing asset classes and a template for investment expense reporting.

Investment Fees

On June 10, Gov. Greg Abbott signed Senate Bill 322, mandating public pension funds to provide a “comprehensive analysis of the retirement system’s investment process that covers all asset classes,” according to the text of the law. The bill requires pension funds to begin reporting, by May 1, how much they spend seeking returns through bonds, stocks, hedge funds, real estate, private equity, and cash. The law and the rules for such disclosures do not require pension funds to provide the name of the investment managers who manage the asset class.

Click chart to enlarge.

However, newly appointed PRB board member Christopher Zook suggested that a fee reporting template encourages such detail in the interest of full transparency. Zook is the founder, chairman, and chief investment officer of CAZ Investments, a firm that invests its personal capital with those of its clients on a performance basis. The Board also appointed Zook to chair a new Investments committee, which will convene sometime before the next full Board meeting in June.

Read our guide to the new rules in a past edition of TEXPERS' Pension Observer membership magazine.

Training

The Board also approved a rule decreasing by half the reporting requirements for trustee and administrator training. Before the rule change, systems reported twice a year on the four hours of training their trustees and administrators obtained over a two-year cycle. PRB staff believe that yearly reporting will suffice to meet the statutory requirements of its Minimum Education Training, which the Board established in 2013. From now on, public retirement systems will need to inform the PRB of training its trustees and staff have received by Sept. 1.

TEXPERS is offering training May 2, the day before its annual conference, May 3-6, on Galveston Island. Click to register for Basic or Advanced trustee training.

Actuarial Health

Also, during the meeting, agency staff reported on key statistics of actuarial health for the 99 systems which the agency monitors. Staff actuary Kenny Herbold noted that 30 pension funds updated their stats from an Oct. 17 report, thereby providing a better sense of overall pension system health. The number of pension systems not meeting the PRB’s recommended amortization period of 30 years or less declined by one system, from 37 to 36. But the number of systems in an infinite amortization condition increased by five to 13, indicating that the 2018 market declines are now being factored into the PRB’s actuarial report. According to the actuarial report, only three of Texas’ 99 systems now target a return of 8 percent or higher. This is a multi-year low.

Target Rates

PRB actuarial staff also presented a new chart showing the distribution of target rates among categories of plans. Board members Keith Brainard and Marcia Dush seized on the fact that most plans organized under the Texas Local Firefighters’ Relief and Retirement Act still target higher rates of return than other types of systems.

The 42 TLFFRA funds average a 7.52 percent rate, while the Texas average is 7.29 percent and the national average is 7.27 percent. They noted how the high rates might not be in the systems’ best interest, considering that payroll growth assumptions and expectations for city contributions have not been met in recent years. The Board also noted how the district and supplemental plans’ target rates average 6.96 percent, significantly below the Texas and national averages.

The Texas Pension Review Board is mandated to oversee all state and local government public retirement systems in Texas regarding their actuarial soundness. The next meeting of the Pension Review Board will be on Jun. 30. Meetings of the investment and actuarial committees are likely to be held in March and April, according to agency sources.

About the Author: 

When it comes to retirement, 

public employees are looking for security

It’s St. Valentine’s Day and the Texas Association of Public Employee Retirement Systems asked a few of the nonprofit’s board members to share their love of defined-benefit retirement plans.

Based on their comments, their earnings represent their commitment as police officers and firefighters to their communities. Their retirement benefits are hard-earned after putting in years of often dangerous work and contributing their own funds to their programs. The benefits allow them to have a safety net of income for spouses when Social Security may not provide enough or anything at all when they die.

If your unfamiliar with defined-benefit pensions let’s give you a brief description. Essentially, it is a retirement safety net that firefighters, police officers, educators, and millions of other state and local government workers in Texas earn in exchange for their job dedication – and honestly, often low wages. Providing retirement benefits help state and local governments compete with the private sector in the recruitment and retention of public employees.

Studies have shown that 401(k)s and other defined-contribution plans are not as successful in ensuring public employees have a secure retirement. Those investing into 401(k)s or similarly constructed defined-contribution pension plans on their own also are not investing enough and do not know how to invest their hard-earned money properly. Plus, Social Security either won’t provide enough retirement income or, in many cases, none because some public employees do not qualify for the federal benefit.

Also consider that millions of Texans have not saved enough for retirement. Without enough income, older adults will not be able to afford the resources that enable them to live independently, pay for medical and other health care expenses, and continue to contribute to society. Defined-benefit pension plans provide a consistent and predictable stream of revenue to public employees – the men and women who have dedicated their careers to the public sector (to you).

A defined-benefit plan delivers retirement income with little effort on the part of public employees while providing retirement security. And unlike private-sector workers, public employees share in the cost of their retirement benefits. A public employee’s contributions typically make up a set percentage of their salaries.

How critical is the need to offer public servants a secure retirement? Retirement benefits is an essential job feature, even more so than salary, according to a newnational poll by the nonprofit, nonpartisan National Institute on Retirement Security.

In a published report on its findings, nearly all state and local workers (93 percent) indicated in the survey that pensions incentivize public workers to stay with their jobs. Even more agree that a pension is a useful tool for attracting and retaining employees. NIRS published the results of their polling in a report, State and Local Employees Views on Their Jobs, Pay and Benefits, in November. 

Here is what else the NIRS poll found:

• Cutting benefits could have severe workforce consequences. Seventy-three percent of respondents indicated they would be more likely to leave their jobs if their pensions were cut. 

• Nearly 92 percent of all state and local employees believe that abolishing secure-retirement plans for public employees would weaken a government’s ability to attract and retain qualified workers. A majority also indicates that doing away with pensions would undermine public safety and the U.S. education system. 

• Among Millennials, those who reached young adulthood in the early 21st century and are collectively known as “dissatisfied job hoppers,” 84 percent working in state and local government indicate they are satisfied with their current jobs. Nearly 74 percent claim that a pension benefit is a significant reason they decided to work in the public sector, and 85 percent said they plan to stick with their current employer until they are eligible for retirement or can no longer work. 

That’s enough statistics. Let’s hear from some of TEXPERS’ own board members, who have or still work in public-sector jobs:

"I love my pension because it represents the years I worked as a firefighter for the City of Big Spring, Texas. The City of Big Spring Fire Department first initiated the pension plan back in the late 1930s and early '40s. Through the many years of change, the trustees have made steady improvements to the plan with the help of city leaders. The retirement plan provides security for my family and me."

- Paul Brown, TEXPERS Board President 

Big Spring Firemen's Relief & Retirement Fund 

Here are a few job-specific fact sheets provided by NIRS:

Firefighters (double click images to expand)

 

Police (double click images to expand)

 

Teachers (double click images to expand)

 

State Employees (double click images to expand)

 

The Texas Association of Public Employee Retirement Systems is a statewide nonprofit educational association organized in 1989. Our members are trustees, administrators, professional service providers, employee groups and associations engaged or interested in the management of public employee retirement systems. TEXPERS member systems and employee group members represent 2.3 million active and retired public employees with assets totaling nearly $89 billion. To learn more, visit www.texpers.orgwww.texpers.org.