One week ago, an increasingly gloomy Morgan Stanley (which recently called the start of a bear market for US stocks) issued its 2019 credit forecast, which was a scathing preview of the challenges facing both HY and IG credit: “the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, has begun and will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.”
Now the Wall Street titans are joining the call.
During the Goldman Sachs Financial Services Conference on Wednesday, Apollo co-founder Leon Black pointed out the obvious, namely that the credit markets are facing excesses as investors chase yield. As a result the credit markets “have gone to bubble status,” according to Black, who somewhat predictably, also said that equity markets have not. After all, warning of a bubble in the equity markets would mean that a private equity firm would have to go in hibernation for the foreseeable future. Bonds, however, are other people’s problems:
“The amount of covenant-less debt is more than 2007. You have a thirst for yield that exists on a global basis. So there is true excess.”
So since it’s a bubble, and it is – still – a seller’s market (but that is changing fast) Black said that in this environment his private equity business tries to get as much covenant-lite as possible, and fixed rate debt. And of course, Apollo takes the opposite approach in its credit business where the firm makes sure to have covenants.
“We try to play a more conservative, cautious role in a bubble environment,” said Black, noting that the PE firm’s credit and insurance operations offer the most growth potential.
Black is right to be skeptical about the “bond bubble”, because as Morgan Stanley’s Adam Richmond predicted last month,the vulnerabilities, which are always tough to spot on the way up, will become increasingly apparent on the way down; as is always the case. In the chart below, Morgan Stanley shows an updated version of a table it uses to monitor the excesses in this cycle. In short, the excesses/imbalances are very much present, driven in part by such a long period of extremely low rates, which drove investors to reach aggressively for yield, and non-Financial corporates, in particular, to issue significant volumes of debt. And here even more bad news from Morgan Stanley, which notes that in many cases these risks look even worse today than when the bank last ran the analysis at the end of 2017. Below Morgan Stanley provides a few examples why the bear market in credit will become increasingly more self-evident:
- In the leverage loan market, covenant quality is weaker than in 2007, the cushion beneath the average loan is lower and 1st lien leverage levels are higher. 48% of LBO transactions are levered over 6x vs 51% in 2007, but as a part of those leverage numbers, 27% of deals have EBITDA adjusted for prospective cost savings/ synergies vs only 15% in 2007. 22% of loan issuance was B- or lower in 2018 vs 15% in 2017 and 13% in 2007, driven in part by record CLO demand/issuance.
- IG debt outstanding has grown by 142% in this cycle and non-Fin BBB debt has grown by 181%. IG leverage is 0.68 turns above 2007 levels today. Non-Financial corporate debt/GDP has never been higher. And IG interest coverage, which used to be a bright spot is now below 2007 levels.
- The loan market has grown by 88% in this cycle, with 24% growth just since the beginning of 2017. Much has been made about a shrinking HY market. Remember, HY debt outstanding has still almost doubled in this cycle, just much of that growth occurred in the first half, not that different from how it played out in 2006/07, when most of the leveraged finance growth also came from loans. Additionally, 64% of speculative grade debt has a corporate family rating of B2 or lower today vs 53% in 2007.
- 2018 was a record year for M&A loan issuance and 25% of IG supply was issued to fund M&A this past year, while stock buyback volumes (ex-fin) hit a record this past year.
- Certain investors have reached out the risk spectrum for yield aggressively in this cycle, given rates at or below zero globally for many years, with non-US ownership of US corporate bonds increasing to 30%, as one example, although declining in 2018 on the back of rising currency hedging costs.
- While consumer balance sheets are clearly healthier in this cycle, non-mortgage consumer debt/GDP is just off of record levels.
- CRE prices are ~25% above prior cycle peaks. We have seen lax underwriting quality in this cycle in pockets of consumer credit (e.g., autos), also shown in the table.
Finally, here is the Morgan Stanley credit cycle – or as Black might call it “bubble” – checklist. As the bank puts it, “a variety of indicators pointing to a very late-cycle environment, and in many cases at more extreme levels than even this time last year.”