Markets have been very volatile over the past week, resulting in a repricing of high yield and commodity related credit risk. With lending standards tightening, global growth stubbornly low, and commodity price volatility remaining high, we continue to advocate a defensive, high quality position in corporate credit.
Market volatility has increased this month. The sell off has been most pronounced in high yield with spreads wider by approximately 100 basis points (bps). In contrast, the investment grade market has widened by 10 bps with the majority of that widening driven by the Energy and Metals and Mining sectors. We believe the primary drivers of this underperformance are: (1) commodities, (2) poor market liquidity, and (3) reduced demand for credit risk.
Commodity prices came under renewed selling pressure after OPEC failed to adjust its production target and Chinese economic data was lackluster. Moody’s lowered its commodity price assumptions, increasing the risk of credit rating downgrades. And, high yield companies took advantage of the bear sentiment and lower security prices to pursue distressed debt exchanges, setting off a panic among unsecured bondholders. Management teams at investment grade companies have reiterated that although they have secured debt capacity, they do not intend to use it. Our analysts are comfortable with the liquidity outlooks of the credits on AAM’s Focus List for the near term, as such, we do not expect investment grade companies (or fallen angels aspiring to return to investment grade) to pursue distressed debt exchanges.
Market liquidity seasonally sours at the end of the year and this year is no exception, especially after broker dealers increased their corporate credit inventories over 200% since the end of October 2015. This, in addition to the contraction and repricing of the repo market due to regulatory changes and the negative headlines surrounding the mutual fund closes, negatively affects an already illiquid corporate credit market.
Lastly, an area that we have been acutely concerned with for the past 12 months is the trend in lending standards in the bank, non-bank, and credit markets. In the third quarter of 2015, for the first time since the European related debt crisis in 2012 (and prior to that, before/after the last recession), banks tightened their lending standards citing a less favorable, more uncertain economic outlook and worsening of industry specific problems. Historically, lending standards has been a leading indicator for the change in investment grade spreads. Moreover, we are seeing conditions outside of the bank market worsen. The Credit Managers Index measures non-bank lending conditions and while the overall measure remains slightly above the “contraction” zone, the leading indicator in this Index weakened, and is now firmly in contraction territory as both manufacturing and service sector “accounts for collection” deteriorated. Global growth remains low and U.S. growth has disappointed this year, causing investors in higher risk securities (e.g., CCC rated) to reprice risk due to lowered future cash flow projections. CCC credit is as wide versus higher quality B rated paper as it has been since 2008 – 2009, reflecting the default risk in that portion of the market. However, default rate estimates continue to be quite low at around 3-4% for 2016, mostly reflecting the expectation for commodity related defaults.
With lending standards tightening, global growth remaining stubbornly low, and commodity price volatility remaining high, we and our high yield sub-advisor, Muzinich & Co., continue to advocate defensive, high quality, liquid credit portfolios. The risk premiums to take credit risk are lackluster. For example, the pick up in yield for a BBB versus A rated non-financial credit remains approximately 65 bps when excluding Energy and Basic Industries. We wait for an opportunity to get more aggressive in credit when: (1) credit reprices and the cost of debt gets closer to the cost of equity as is typical when a cycle bottoms (that differential is currently over 200 bps), (2) management teams begin to shift their focus to balance sheet improvement, and (3) commodity prices stabilize.
Elizabeth G. Henderson, CFA
Director of Corporate Credit
For more information, contact:
Colin Dowdall, CFADirector of Marketing and Business Development
John Olvany, Vice President of Business Development
Neelm Hameer, Vice President of Business Development
30 North LaSalle Street
Chicago, IL 60602
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