Cembalest: The Tide Has Turned for Corporate Credit
"If it keeps on rainin', levee's goin' to break," Led Zeppelin's Robert Plant once crooned.
According to a new report by Michael Cembalest, the proverbial levee has already broken in credit markets.
The chairman of market and investment strategy at JPMorgan Chase’s asset management group posits that huge influxes of money into corporate bonds have combined with vast structural changes in the market to give the asset class all the fragility of an overloaded flood bank. With outflows from corporate bonds now accelerating, the bulkhead of rampant investor demand that has helped keep prices afloat is already breaking, he said in a note to clients.
"There have been two narratives to watch regarding credit since 2008: the surge in corporate issuance and demand by investors frantically searching for yield, and the changes in ownership, liquidity and turnover in the wake of new regulations," Cembalest wrote. "From 2008 to 2014, the first narrative dominated and credit spreads tightened. Now that outflows are picking up, these two narratives are on a collision course that has important implications for investors. Increasing volatility and rising credit spreads create both risk and opportunity for investors."
Since 2009, non-financial companies in the developed world have increased their sales of new bonds by $2.5 trillion, according to Cembalest's figures. While such growth wouldn't normally be a problem, given the historic tendency of investors to buy and hold such debt until maturity, the market has experienced a step-change in its structure, including increased bond ownership by mutual funds and exchange-traded funds that promise investors instant withdrawals. So-called "cross-over buyers" have also been pushed out of their comfort zones, thanks to a rampant search for yield, helping to fuel a decline in credit quality while simultaneously raising the possibility that inexperienced investors will jump ship at the first signs of rough water.
"As for fundamentals of high-yield issuers, to me they never justified ex-energy high yield spreads in April 2014 that were at their tightest levels on record. In aggregate, while interest coverage and cash flow margins are stable (reflecting benefits of low interest rates and low wage growth), leverage has been rising and sales growth is weak," Cemablest added. "Furthermore, aggregate index data is not as useful in credit, since weak issuers drive defaults rather than the average issuer."
Persistent worries over the ability of investors to trade debt without overly affecting its price in the face of new financial regulation also means that the market now has an unnerving tendency toward jumpiness in exchange for insulation against big bank losses. "Unfortunately, reduced systemic risk may come at the cost of greater market risk," Cembalest said, echoing an argument that has been made by others. "Many new rules and proposals make it harder for banks to expand their balance sheets in a time of crisis, either to take risk or to facilitate risk-taking by others."
He argued that such structural issues were largely hidden by massive inflows into the asset class. It is only now, as the tide flows out, that the market's true dearth of liquidity is revealed and we, to borrow the words of Warren Buffett, get to see who's been swimming naked in corporate credit.
While a weakening levee will provide the watery grave to bury many naïve or reckless bond-buyers, Cembalest suggests that opportunities exist for canny investors with the benefit of a lifesaving cash reserve that can be deployed once spreads have widened.
"The sense we have is that they are preparing for a more volatile 2016, and prefer to preserve ammunition for compelling opportunities that may arise," Cembalest said. "The chart [below left] shows aggregate cash balances for the directional and distressed managers."
In fact, some hedge funds are already taking advantage of the turning tide, he said.
Some are undertaking capital structure trades that involve buying the senior debt of a company and shorting its subordinated debt, while risky structured credit trades that involve speculating on the diverging fortunes of slices of collateralized loan obligations are also back in vogue.
Investors tempted to go bottom-fishing in the flood should beware, however.
"Rising spreads can be tempting, but if investors jump in too soon, they need to be prepared to see prices continue to drop before they eventually stabilize, even when underwriting the right credits," Cembalest concluded.