The turning point of the credit cycle

22 February 2019

By Sheldon MacDonald, co-fund manager HC Verbatim Multi-Index Funds

After a long period of meagre rates and overflowing liquidity, the US economy is now entering into the late-expansion phase of the credit cycle: equity markets are near their all-time highs, and interest rates are rising.

Ten years on

Its ten years since the glut of unsustainable credit that led to the failure of Lehman Brothers, a systemically-important financial institution, which created a seismic shock leading investors to lose confidence in the entire global financial system. Today's financial system is much safer thanks to the reforms put in place after 2008 with better-capitalised banks and increased regulatory supervision. Now, a decade after the financial crisis, many are asking if there are parallels in current credit markets and those in the run-up to the crisis.

Leverage in the markets again?

Leveraged loans are corporate loans with payments linked to interest rates set by central banks. Demand for this type of asset, from borrowers and investors, often peaks at this stage of the business cycle. The benign credit environment, higher interest rates and strong fundamentals such as solid earnings and low default rates are supporting the market, and investor demand shows no signs of reducing.

One of the side-effects of these benign conditions has been that total corporate leverage is hovering at pre-crisis highs. So far, this has been offset by rising company earnings but a significant change in this upward momentum could cause the storm clouds to gather. The loan market has grown markedly over the past ten years, reaching $1 trillion in 2018, meaning the loan market has overtaken the high-yield bond market in terms of size. The majority of recent issuance has been for refinancing, and we have also seen record M&A activity in 2018 year, due in part to tax law changes in the US. One of the main selling points of leveraged loans has been their seniority to bonds and stockholders in the event of default. But protection for lenders is at an all-time low and liquidity in a crisis could dry up if loan prices decline across the board.

Covenant-lite

We have never seen weaker loan covenants, not even in the run up the financial crisis. As demand continues to be strong, loan terms keep softening. More than 80% of new loans are ‘covenant-lite’ loans, with little financial maintenance restrictions. Borrowers now have the flexibility to issue more debt, pay out shareholder dividends and even put collateral out of lenders' reach.

Rising interest rates

The leveraged loan market is the one corner of the credit markets that is booming as interest rate increases from the Fed have dented returns for fixed-rate bonds. Leveraged loans offer protection rising interest rates by providing a return linked to the interbank rate with a floating interest rate typically pegged to the three-month London Interbank Offered Rate (LIBOR).

Is CLO the new CDO?

Bonds based on leveraged loans have surged similar to those based on mortgages pre-crisis. This time, the fuel isn’t subprime mortgages but risky corporate debt.

Leveraged loans are now being packaged into collateralised loan obligations (CLOs) and sold to investors, and the CLO market has grown to match the size of the collateralised debt obligation CDO market at its pre-crisis peak.

It’s possible that bank loans will suffer a particularly severe downturn when the current cycle turns. A big reason for that: the quality of today’s loans has declined as banks have relaxed approval criteria on leveraged loans and their restrictions – which require a minimum amount of collateral, have been easing.

What goes up must come down

There are no immediate worries about the loan market; default rates are low partly because of the flexibility that the weak covenants give to borrowers. However, as business cycles mature, it is likely that a recession will follow the current cycle. The worry is that weaker companies with substantial debt loads could find it tougher to make payments on loans putting this asset class at risk of distressed loans or reduced liquidity.

We don’t think a recession is a likely event this year, but when a downturn arrives, we could see a rise in defaults. This could once again pose a threat to the financial system; however, there are now some mitigating factors that limit potential avenues of contagion. We have a better-capitalised banking system and regulators that are better prepared to deal with a systemic crisis. The industry needs to embrace the lessons of the past and prepare for the future.

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