Risky business?

High-yield debt is grabbing the headlines again. This blog has picked HY as its potential ‘canary in the coal mine’ – but is it about to stop chirping? This week I’ve picked out three charts that highlight the risks and two that suggest HY debt has a song or two to sing yet.

High-yield bond indices are on track for their worst month since January 2016 and three deals have been pulled from the market in the last week. So how worried should we be?

As many commentators have rightly pointed out, other HY deals have got away and most of the market pressure is in telecoms and retail – two especially pressured sectors. The fall should also be seen in the context of a long rally. When volatility is this low, any adverse movement seems noteworthy.  So, is there nothing to see here? May-be not right now. But, there’s no smoke without fire and, given how far and hot this rally has run, it’s worth taking a look under the hood. To do this I have five (hopefully) illuminating charts.

1. The squeeze

“The environment of continuing monetary accommodation—necessary to support activity and boost inflation—may lead to a continued search for yield where there is too much money chasing too few yielding assets, pushing investors beyond their traditional habitats”

IMF Global Financial Stability Report October 2017

IMF QE

The IMF quote above neatly sums up the paradox at the heart of our recovery. What if the cure for the last crisis is fueling the next one? The chart above – also from the IMF – illustrates the root of the problem. Their latest research shows that of the US$1.5t of debt issued by advanced economies since 2010, two thirds have been acquired by central banks. The IMF also forecasts that bond buying from the Bank of Japan and the ECB will exceed new issuance in the next five years.

Thus we’re still seeing a growing pool of money chasing a shrinking pool of assets, which is leaving safe assets in particular in very short supply and yielding next to (or less than) nothing. All of which has far reaching consequences.

2. The quest

Since 2007, this drop in yields has pushed investors beyond their normal risk mandates, compressing spreads and lowering volatility. The latest Bank of America Merrill Lynch survey of investors shows that a record high of investors saying that they are taking above normal levels of risk in their investment. The chart below sums up neatly why this might be.

imf yields

Theoretically, monetary policy normalisation removes the central bank as a major competitor for assets, which we can see start to happening in chart one. But, much of this credit availability in ‘safe assets’ is in US treasuries and the build-up of dependence and unconventional portfolios make withdrawal unpredictable. Central banks have been advised by a multitude of agencies to move slowly. Inflation isn’t providing an immediate push. So although all but the bank of Japan are now on the road to tightening, it’s still at a glacial rate and even slower than most expected even this time last year.

3. The offer

On the evidence above, there’s no immediate sign of liquidity drying up. That’s not entirely a bad thing – obviously – but the longer the dance, the more risks build. And this isn’t just an issue of investor portfolio, it also applies to lender protection. Data from ratings agencies shows that share of lower-rated companies has increased, but the compensation for credit risk in key corporate bond markets has fallen – as has the protections offered to lenders. They too are scrambling to find debt to invest in, creating high levels of competition.

Covenant fall

4. The upside

By now, you might be starting to think about tins and bottled water. But, as I hinted at the start, this is a complex situation with several mitigating factors. For a start, the banking system is healthier and more robust than before the crisis. In particular, international important banks have become more resilient, with stronger capital and liquidity lessening the chances of a systemic issue developing across the financial system.

Crucially, for HY companies, major economies are also still reporting a synchronised improvement in global activity – which is a powerful force. It helps to explain why EY’s Capital Confidence Barometer shows such a significant increase in corporate earnings confidence in the last six months.

CCB Global earnings

Amidst this positivity some sectors are feeling economic and structural strain. Telecoms is heavy indebted, in a state of upheaval and a significant portion of the high-yield debt market. Retail is similarly undergoing structural change. What this strong global economic backdrop should do is help investors hold their nerve and prevent contagion.

5. The upshot

The other major confidence building factor is an exceptionally low level of HY defaults. The base case from Moody’s is for European speculative-grade defaults to dip below 2% in 2018 – and below 3% in the US. Fundamentally, this is should support investor confidence. But, of course there is a paradox here too. One of the reasons why defaults are so low is the pull of investors into riskier credit.

Euro defaults

And it’s the presence of so many paradoxes, contradictions and sensitivities that helps to explain why we’re seeing such going into 2018. Moody’s base case is very close to their optimistic case, that economic growth will continue to help smooth the exit from monetary support. But, with so many investors in unfamiliar areas, rising levels of leverage and high valuations, it’s impossible to say never and their pessimistic scenario is puts default rates at their highest since 2009-10. The IMF have also come up with a downside scenario, in which a sudden repricing of risks leads to a financial crisis about a third as severe as the last one.

A more positive but riskier outlook with polarised scenarios…very 2017.

 


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