insight
The End of the Credit Cycle?: AAM Corporate Credit View (Fall 2015)
October 12, 2015
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Volatility remained high in all markets with investment grade credit spreads widening 23 basis points (bps) versus Treasuries in the third quarter. The main driver of this widening was falling commodity prices in response to continued weak data from China and global growth concerns.
Repricing Risk
The Federal Reserve’s decision and communication led to investor consternation in the latter half of September. The prospect of higher rates concurrent with the increased risk of slower global growth resulted in a repricing of risk.
This was most evident in the high yield market with spreads widening 153 bps in the third quarter. Investors pushed back in the new issue market, demanding much higher yields (e.g., Frontier Communications, Altice, Olin). In investment grade, we witnessed issuers pulling deals from the market after poor investor response as well, a dynamic we have not experienced in some time. The CLO (Collateralized Loan Obligation) market has also suffered with credit quality erosion and market volatility impacting pricing and originations. Appreciating the importance of credit availability and creation to the health of the credit market and economy, we are concerned with these events.
We cited the increased risk of fallen angels in last month’s Corporate Credit View (“Fallen Angels Expected to Increase”). The market recognized this risk in the third quarter, repricing many BBB rated credits, with $211 billion of debt across 56 investment grade issuers trading like high yield credits[note]Stephen Antczak, CFA, “Fallen Angels: How many, how to cope,” Citi Research, October 2, 2015[/note].
Market Vulnerabilities
The first signs of credit contraction cause us to increase the top end of our range for spreads. We had entered 2015 with an expected range of 120-175 bps (Exhibit 1). Considering the change in quality and duration of the Barclays Corporate Index since prior points in the cycle, as well as corporate fundamentals today, we have modeled downside risk to be 225 bps.
However, risk is skewed to the downside due to the difference in liquidity conditions (“The Perfect Storm? Fixed Income Portfolio Management in a Reduced Liquidity Environment”). In the Royal Bank of Scotland’s (RBS) September Survey 79% of investors believed that we are moving to a structural phase of high asset price volatility. As the survey results show, this was the second biggest fear among investors (first being China). RBS states that “declining liquidity and an increase in herding may exacerbate volatility during times of stress, with the IMF (International Monetary Fund) highlighting an increase in correlation among major asset classes and between fund positions, since the crisis.”[note]Alberto Gallo, “The Silver Bullet|Credit nearing breaking point: Stay Short,” Royal Bank of Scotland, September 30, 2015.[/note] Regardless of fundamentals, we believe the market needs to reprice for this level of volatility, hampering a return to 120 bps.
Exhibit 1: U.S. Corporate Investment Grade OAS
Source: Barclays, AAM as of 9/30/2015
We believe BBB rated credits away from the Energy and Basic Material industries are particularly vulnerable, if the credit cycle has ended and spreads widen. The spread differential (i.e., basis) of A and BBB rated Industrial credits has increased due to commodity related sectors, as the risk premium for other BBBs (excluding Energy and Basics) has not widened (Exhibit 2).
Exhibit 2: BBB-A Industrial Rating Basis, excluding Energy and Basics
Source: Barclays, AAM as of 9/30/2015
Additionally, cyclical sectors away from commodities have performed in line with more defensive sectors. We believe the risk premium for economically sensitive sectors could also widen with sectors within Consumer Cyclicals particularly vulnerable.
Exhibit 3: Spread Changes for Sub Sectors YTD
Source: Barclays, AAM as of 9/30/2015
We would expect widening in Financials as well. They have outperformed year-to-date, but would be impacted in a credit correction, as increased credit defaults would be a drag on earnings and capital levels. We are watching bank lending standards and credit loan growth closely for additional signs of credit contraction. We note the third quarter loan growth was less than half the rate realized in the second quarter due to a slow down in commercial and industrial (C&I) lending.
Exhibit 4: Finance – Industrials Spread Difference
Source: Barclays, AAM as of 9/30/2015
The banks continue to operate in an opaque regulatory environment. A draft form for TLAC (Total Loss Absorbing Capital) is expected to be released by the Global Financial Stability Board before the G20 finance meeting in November. However, the Fed and OCC (Office of the Comptroller of the Currency) are expected to tweak it for the U.S. system, which is expected to take longer. Therefore, debt issuance requirements (needed to increase capital levels) may become clear later this year with a four to six year implementation period. We believe the long implementation timeframe is manageable, thus we do not believe this will be a systemic issue or stress on the system.
Summary
We are in the late stage of the credit cycle, and signs are emerging that we may have reached the end. If that proves true, we would expect spreads to widen and rating actions to become more punitive. Companies have increased leverage at a time of slowing earnings growth to increase shareholder returns. Regardless of whether we are at the end of the cycle, we expect this credit deterioration to continue to be a headwind for spreads and an impetus for rating downgrades. In the past, economic cycles have lagged credit cycles by approximately 12 to 24 months. Therefore, we would not expect management behavior to become creditor friendly until the risk of a recession increases. Although spreads have widened, this is a time to remain defensive and selective. As growth forecasts are revised lower and credit appears to be contracting, we are growing increasingly more cautious.
For more information about AAM or any of the information in the Corporate Credit View, please contact:
Colin Dowdall, CFA, Director of Marketing and Business Development
John Olvany, Vice President of Business Development
Neelm Hameer, Vice President of Business Development
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.
This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.