Ever since the global financial crisis of 2007-8, investors have been on the lookout for what might trigger the next recession. With corporate debt in the US reaching an all-time high of 46 per cent of gross domestic product (GDP)1, it is the credit market that has become the chief cause for concern.
Source: Pictet Asset Management
In recent quarters, most of that borrowing has taken the form of leveraged loans. As issuance of leveraged loans has risen rapidly, covenants that protect investors have weakened, credit quality has deteriorated and the market’s ability to withstand stress in its current form remains largely untested. The concern now is that if a bubble bursts here, it could affect mainstream fixed income asset classes like high yield bonds. But there is a silver lining for bondholders: leveraged loans increasingly look like a standalone asset class, possessing characteristics that are sufficiently different from those of the high yield market to limit any contagion.
For a start, the overlap between the two markets – the proportion of companies that have both leveraged loans and high yield bonds outstanding – has fallen, reducing the risk of any spillover. The percentage of loan-only issuers in the US has increased to 79 per cent in 2018 from 70 per cent in 20172. This is negative for the leveraged loan investors as, without a high yield cushion, this form of borrowing becomes first in line for any losses in the event of bankruptcy.
The lack of overlap between the asset classes is also reflected in their respective sector make-up. While US high yield is dominated by communications and energy companies, leveraged loans are particularly popular among consumer discretionary and tech businesses (see Fig. 1).
fig. 1 different emphasis
Sector breakdown for US institutional leveraged loans market compared to US high yield market
Source: Bloomberg; data as of 31.12.2018
Secondly, there has been a weakening of covenants – rules on matters like leverage, collateral and payment schedules – in the credit market This is much more relevant for leveraged loans than for high yield debt. This is because leveraged loans sit further up the capital structure, where the protection offered by covenants tends to be more valuable and the impact of dilution from increased corporate borrowing is more keenly felt. According to Moody's ratings agency, leveraged loans' covenant quality has dropped to its weakest level ever.
Net issuance levels also offer some comfort to holders of high yield bonds. While the outstanding value of leveraged loans in the US surged by 54 per cent between 2013 and 2018, the amount of high yield credit contracted by 13 per cent3. With a smaller pool of assets available, it should be easier for bondholders to retain value and avoid bubbles.
Furthermore, in contrast to what’s happening in leveraged loans and investment grade debt, the average credit quality of high yield bond issuers has not deteriorated. In the US, the average rating for a non-investment grade bond has stayed at B1/B+ level for many years, while in Europe it has actually gone up one notch to BB3/BB-4. This could partly reflect the fact that leveraged loans have been more frequently used to fund mergers and acquisitions and leveraged buyouts (LBOs) – activities which could potentially lower the creditworthiness of borrowers.
However, non-investment grade credit is not problem-free. The asset class has seen a steady increase of leverage (see Fig. 2). Although this is still lower than gross leverage within leveraged loans – where median debt-to-EBITDA levels are greater and 50 per cent of borrowers have a ratio of five times or more – investors would do well to monitor the high yield market for any signs of growing stress5.
Fig. 2 rising leverage
US high yield (ex financials): median debt-to-EBITDA ratios
Source: BoAML, S&P Capital IQ, Pictet Asset Management. Data covering period 31.12.2005-31.12.2018
Overall, though, the increase in debt ratios has been much more significant in the leveraged loans market – which is unsurprising given the surge in borrowing there. Add in the erosion of lending standards and the reduced overlap with the high yield market, and loan investors have ample grounds for concern. Non-investment grade bonds might be riskier on paper, but the gap is shrinking. Which is why we believe that when the loan crunch comes, high yield won't suffer more than other asset classes.
Supriya plays a vital role in providing the Multi Asset team in London with in-depth investment research that helps steer tactical and strategic asset allocation decisions. She has built out cross-asset decision-making quantitative indicators covering valuation, fund flows and macro areas that are used across the firm. Supriya provides the Pictet Asset Management Strategic Unit with monthly Sentiment and Technical analysis and contributes to long-term thought leadership pieces.
Having joined Pictet Asset Management as a strategist in 2012, Supriya moved to the Multi Asset London team in 2018, where she assists the portfolio managers in decision-making and generates trade ideas for the balanced and multi-asset products. Supriya also communicates the team’s investment strategy to institutional clients and regularly appears on international media channels.
Supriya started her career at Morgan Stanley in 1999. She then worked as an Equity Strategist and Investment Analyst at Lehman Brothers from 2005 to 2009 after which she joined Aviva Investors as a Macro Strategist.
Supriya holds a BA in Economics and International Relations from Mount Holyoke College, Massachussets, USA and an MBA from the Harvard Business School.
About
Andrew Wilmont
About
Andrew Wilmont
Andrew Wilmont joined Pictet Asset Management in 2018 and is a Senior Investment Manager in our Developed Credit Markets team focused on European High Yield. Before joining Pictet, Andrew spent four years at Neuberger Berman as Managing Director for European High Yield. Between 2005 and 2014, he headed the European/ Global High Yield team at Axa Investment Managers. He started his career in High Yield as a Corporate Analyst at Saudi International Bank in London at the inception of the European High Yield market in 1997. Andrew holds and MSc in Business and a LLM in Corporate Law from Vrije Universiteit, Amsterdam. He is a Chartered Financial Analyst (CFA) Charterholder.
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