Bankers are fond of saying “bad loans are made during good times.” With equity markets reaching new highs, volatility and interest rates hovering around historic lows, positive economic growth, and increased merger activity, we could characterize today’s environment as the “good times.” Since credit markets run in cycles alongside the broader economy, investors need to be alert to the trends and habits that portend future market turbulence. Today’s conditions look in some ways like the excesses that preceded the previous crisis, but there are important differences.
It’s true we are seeing record issuance of high-yield bonds and leveraged loans, as well as the return of covenant-lite loans. J.P. Morgan reports collateralized loan obligation (CLO) issuance in the United States is on track to reach a record $100 billion by December. These trends are controversial because they remind investors of the days before the global financial crisis (GFC) when heavy issuance, structured products, and weak covenants were perceived as a witch’s brew.
However, this is misleading on several counts. Losses in the corporate loan market during the last cycle were fueled more by poorly constructed leverage at hedge funds and other institutional investors that were forced to sell to meet margin calls, thus putting pressure on prices. Simultaneously, Wall Street banks were saddled with over $250 billion of inventory they could not sell at reasonable prices given the global financial meltdown. Today, syndicated loan holders are far less levered and banks own a fraction of the inventory. CLOs became notorious in the GFC, but defaults were concentrated in market value products, not cash flow CLOs, which were and remain the predominant form of issuance with an admirably low default rate. Market value CLOs do not even exist today. While covenant-lite loans connote lax underwriting, they can also reflect an issuer’s strength and are often provided to better credits that can demand them.
Current credit metrics belie the convenient view that we’re in an identical pre-GFC era. New issue leverage peaked in 2007 at about 5.3 times debt to EBITDA; it drifted as low as 4.6 in 2009, but the current 4.9 level is hardly cause for panic. Moreover, new issue interest coverage, defined as EBITDA/cash interest, hovers at 2.9, up from 2.1 in 2007, although that coverage ratio could have far less cushion if interest rates spike. Debate also rages about the quality of new issues. Less than 50% of new issue ratings are B or lower compared to four consecutive years pre-GFC when this measure topped 60%. Issuance of CCC bonds as a percentage of total new securities is lower than the previous cycle as well. High-yield bond spreads recently broke 400 bps for the first time since mid-2007 and are only 25 bps from their 20-year average, but are more than 200 bps wider than the 2007 all-time low of 266 bps. Although absolute yields are near historic lows, the recent tightening reflects investors’ confidence about levered companies hoarding cash, rationalizing expense levels, and positive, albeit modest, revenue growth rates.
Regulators and central bankers across the globe have been warning banks to tighten their underwriting procedures to avoid a repeat of the GFC. At the same time, stricter capital requirements under Basel III and the Volcker Rule are forcing lenders to abandon certain markets, creating a void now being filled by non-bank lenders operating out of regulators’ view, underscoring the fact that all credit functions in the economy are not uniform nor do they come from the same sources. Corporate credit markets, for example, are distinct from consumer-driven credit and mortgages, where growth has been tempered. As the Federal Reserve changes course, banks will hold lower inventory while leveraged securities markets remain wide open even as spreads grind tighter. With default rates remarkably low, regulators will have far fewer problems from traditional credit providers in the near term. But in the next downturn they’ll have less information and fewer tools to deploy against shadow banking players who are certainly enjoying the good times.
Myles Gilbert is a Managing Director on the Cambridge Associates Global Investment Research team.