U.S. Credit Markets Are More Sane Than the Frenzy Suggests

Updated on
  • Idiosyncratic risk pricing seen increasing, bears still alive
  • Returns in Oct. suggest market less complacent than feared

U.S. credit investors are blithely ignoring borrower- and sector-specific risks that endanger the bond bull market as the global business cycle enters its final stages.

That’s the narrative bears are pitching as spreads on corporate bonds plumb post-crisis lows, borrowers in the $1 trillion leveraged-loan market command ever-aggressive pricing terms and complex credit derivatives -- sales of which might reach $100 billion this year alone -- boom.

Beneath the bullish surface, however, a slew of investors have the guts to push back against the market euphoria, while idiosyncratic risk -- the extent debt obligations are priced on the basis of fundamentals -- is alive and well.

Here are credit signposts you might have missed: 

  • The contrasting fortunes of obligations issued by U.S. companies with weak balance sheets in October sit awkwardly with the bearish view that benign market conditions have lulled investors to sleep. Cyclical credits were buoyed by higher commodity prices and strong economic data, while companies in retail, health care and pharma were duly roiled after missing earnings estimates. 
  • In other words, economic and sector-driven forces are sparking notable price moves in either direction that’s hard to see at the index level.
  • "In U.S. high yield, idiosyncratic events, earnings and M&A (or lack thereof in telecom) skewed single-name and sector returns, separating the top performing sector (Aerospace & Defense +1.2 percent) from the bottom performing sector (Satellite -2.2 percent) by 346 basis points" Wells Fargo credit strategists led by George Bory wrote Thursday in a report that sketches last month’s divergent credit landscape.
  • "Performance in October and year-to-date is consistent with investors avoiding deep credit risk and highly levered names," says Stephen Caprio, a New York-based UBS Group AG credit analyst. "But I still think investors are too sanguine about liquidity risk and fund outflows, looking at where BB rated high-yield spreads are trading."
  • Still, bullish sentiment in some corners of the U.S. credit market is on the wane. Investors have pared exposures to the $19.4 billion iShares iBoxx High Yield Corporate Bond after a summer boom, as they adjust to the prospect of tighter U.S. monetary policy and a more-constrained outlook for global liquidity
  • Some $617 million flowed out of the exchange-traded product last week alone. What’s more, U.S. high-yield funds reported outflows of $1.2 billion for the week ended Nov. 1, according to Lipper U.S. Fund Flows data.
  • That’s merely a blip given the $180 billion that’s rushed into North American bond ETFs and mutual funds this year through Oct. 11. But the outflows -- coupled with an uptick in the discounts against the value of the holdings of some exchange-traded funds -- suggest bears are coming out of hibernation after October’s issuance frenzy, according to Peter Tchir, a strategist at broker-dealer Academy Securities Inc. in New York. 
  • Even in the ’anything goes’ leveraged loan market, some lenders are pushing back. Office Depot Inc., for example, this week discussed a sweetened loan deal for investors, including a higher yield and other concessions, after lenders balked at the initial pitch, people with knowledge of the matter said. 
  • A tentative leveraged loan repricing by PE Vertiv Holdings LLC this week became the 26th offering so far this year not to make its way onto the syndication pipeline. The provider of electrical power equipment was forced to juice the premium for lenders and downsize the offer by $500 million to $1.75 billion amid weak demand. Meanwhile, Consol Mining Corp. on Monday cut its loan offering by $25 million to $300 million to yield 11 percent.

"There are some signs that idiosyncratic risk, at the very least, is playing a bigger role" in lower-rated debt markets, Tchir wrote in a client note Thursday. To those with a glass-half-full disposition, it suggests market pricing might be less complacent than you think.

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