This is a research report I wrote up earlier today on a specific vulnerability that worries me in the riskier areas of fixed income.
Summary
Over eight years after the end of the Great Recession, the
economic recovery that has slowly but surely powered the United States into a
4.1% unemployment rate and sent stock market indexes to dozens of record highs
this year has now spread around the globe. With heavy-handed support from
leading central banks, financial markets are thriving, with suppressed
volatility and generally-positive economic data supporting both advanced and
emerging economies. Unconventional monetary policies employed by G20 central
banks, particularly the European Central Bank (ECB) and Bank of Japan (BOJ),
have led to an asymmetric recovery in certain sectors of global financial
markets, however, whether directly or indirectly. In this report,
unconventional monetary policies will be connected to the increasing
deterioration of covenants in riskier sections of the fixed income market, and
concerns over systemic risk posed by such sectors of the fixed income market
will be outlined.
Introduction
In response to the 2007-2008 financial crisis and succeeding
deep recession, central banks in advanced economies found that their conventional
monetary policy tools were not as effective as desired. Faced with the zero
lower bound dilemma, leading central banks asserted themselves into uncharted
territory with the use of new monetary policy measures. The most visible and
widely-discussed tool at hand was that of quantitative easing (QE), the process
by which a central bank purchased their nation’s sovereign debt (for the ECB,
up to 33% of each EU member’s sovereign debt), in a bid to stimulate the
economy and lower borrowing costs for consumers. Through such QE operations,
the G4 central banks (the Federal Reserve, the ECB, the BOJ and the Bank of
England) purchased securities that sent their balance sheets to a combined
37.4% of their cumulative GDP.
Figure 1. Source: Bloomberg
The composition of the balance
sheets for each central bank vary, however. For example, the Federal Reserve
invested its $4.5 trillion balance sheet primarily in Treasury securities, as
well as agency debt and mortgage-backed securities (MBS):
Figure 2. Source: Bloomberg
In contrast, the European Central
Bank has accumulated nearly 33% of each European Union member’s sovereign debt,
the threshold of which was set by the Bank and is unlikely to be increased due
to German opposition to the continuation of QE. The ECB also undertook
significant purchases of corporate bonds, a program which also is still
ongoing. The Bank of Japan has employed the most unconventional monetary policy
of the G4 banks, and perhaps of the world. Indeed, the BOJ now employs ‘Quantitative
and Qualitative Easing’ (QQE) and ‘Yield Curve Control’ (YCC), as well as
maintaining a benchmark interest rate of -0.4%. The YCC portion involves the
Bank of Japan maintaining the 10-year Japanese government bond yield at a rate
of around 0.00%. The Bank had stepped in with offers to buy an unlimited amount
of bonds at a rate of 0.11% earlier this year, when the 10-year yield began
climbing, in a motion similar to that of a central bank offering to defend its
currency peg if necessary. As part of its QQE program, the Bank of Japan now
holds significant stakes in the Japanese sovereign debt market, Japanese
corporate debt, Japanese stocks and exchange-traded funds (ETFs), all in bids
to suppress volatility and encourage consumer spending.
The successes and failures of these
varied monetary easing programs are not for discussion in this report. Rather,
we aim to focus in on the Federal Reserve’s quantitative easing operations, and
its consequences as reflected on riskier portions of the fixed income market-
namely, leveraged loans and the high-yield corporate debt sectors.
The Federal Reserve’s QE program was
designed to decrease borrowing costs for consumers, and the suppressed nature
of the 10-year Treasury note yield shows that this has happened.
Figure 3. Source: Bloomberg
With Treasury yields continuing to
plumb record low levels over the last several years due to the Federal
Reserve’s QE, investors have been driven to riskier assets in their search for
yield. A primary beneficiary of this tactic (a deliberate one, at that) has
been the stock market, with the Dow Jones Industrial Average (DJIA), S&P
500 and Nasdaq Composite setting over 100 record closes combined this year.
While this is due in large part to investor enthusiasm over the expected agenda
of President Donald Trump, stock markets were strong and looking stronger in
the months leading up to the 2016 presidential election.
In a sign of investors’ search for
yield, even riskier assets have seen stronger returns than stocks. A prime
example of this is the return offered on Bank of America Merrill Lynch’s High
Yield corporate bond index.
Figure 4. Source: Federal Reserve Bank of St. Louis – FRED.
On an indexed basis, where the
beginning of the 2007-2009 recession was set to 100, the S&P 500 has seen
its value increase by a multiple of 1.8, through the end of October 2017.
BAML’s High Yield Total Return Index, however, has seen its value more than
double over the same period, appreciating by a multiple of nearly 2.2 through
October 2017. It is no secret that investors who favored junk bonds over the
last eight years have been handsomely rewarded- even today, the effective yield
of BAML’s High Yield corporate bond index still tracks above the 10-year U.S.
Treasury note, but that’s where the concern starts.
Figure 5. Source: Federal Reserve Bank of St. Louis – FRED
The effective yield has hit record
lows on multiple occasions since the end of the previous recession, with the
most recent nadir in 2014, though even today junk bonds hold a slim premium
over Treasuries.
Let’s recall the purpose of a
premium. We first recognize that U.S. Treasuries are the risk-free rate, as the
U.S. government will not default on its debt (this has been called into
question over the last decade, but for all intents and purposes, we will leave
this assumption undisturbed). To hold an asset that is riskier than Treasuries,
therefore, leaves investors demanding compensation for retaining that risk.
Such compensation comes in the form of a premium, the higher yield compared to
Treasuries. Relative to Treasuries, highly-rated investment grade corporate
bonds (i.e. AAA-rated or AA-rated) will trade with a small premium to
Treasuries, as they are quite unlikely to default. Riskier corporate bonds,
such as A-rated bonds, will contain a larger premium with their
correspondingly-higher risk, and so on. Junk bonds, sitting at the bottom of
the ladder, are those with the highest risk, and thus the highest premium…
until this economic expansion.
Figure 6. Source: Federal Reserve Bank of St. Louis – FRED
Above is a graph depicting the
spread between Moody’s Seasoned Baa-rated corporate bond yield and the 10-year
Treasury note yield, in percentage points. While we remain above the record
lows reached prior to the 2007-2009 recession, we continue trudging further
down the scale. This depression of the spread indicates investors are willing
to receive less of a premium to hold these risky bonds over U.S. Treasuries, as
investors continue to hunt for yield.
At first blush this chart is not all
that impressive, but let’s view it in tandem with Figure 5. The Baa-10 year
Treasury spread in Figure 6 is low, but the effective yield of BAML’s High
Yield corporate bond index is at or near record lows. So, while the premium for
Baa corporate bonds isn’t as low as it was in 2006, the actual yield of those
Baa corporate bonds is lower, leaving investors with less income overall. That
drive for income we discussed earlier only pushes investors deeper into riskier
segments of the financial markets, and makes them more willing to take on risk
to receive income. This is an intended consequence of the Federal Reserve’s QE
program, but it’s a consequence that is beginning to lead to deteriorating
credit conditions.
Credit
Boom
The Federal Reserve’s intent to make
investors become more willing to take on risks has combined with the Federal
Reserve’s lowering of borrowing costs to increase lending to make a dangerous
entity in high yield bonds and leveraged loans. Let us first review the volume
of total U.S. corporate bonds, U.S. leveraged loans, and U.S. high yield bonds
in a historical sense, respectively.
Figure 1. Source: Bloomberg.
Figure 2. Source: Bloomberg.
Figure 3. Source: Bloomberg.
It is not difficult to ascertain the
trend in the broad corporate bond market. As shown in Figure 1, we are already
well past the previous year-to-date record of U.S. corporate bond issuance,
with just over $1.7 trillion in corporate debt issued through mid-November. The
same is found in the leveraged loan market, with volume once again surging past
the previous year-to-date record to clock in now at $1.2 trillion. We are not
yet at a new year-to-date record in the U.S. high yield sector, currently in at
$300 billion through mid-November. It remains to be seen if a new year-to-date
record will be achieved in 2018 or later, but is unlikely to happen this year.
The volume of these riskier loans is
a testament to investors’ increasingly-frenzied hunt for yield. Unfortunately
for investors, this has placed the bargaining power in the hands of the lender
& debt issuer, given if one investor doesn’t like the terms, another
investor that is more driven for income will take those same terms. This has
led to a startling deterioration in the quality of investor protections on high
yield and leveraged loan securities, as evidenced in the following quote from a
Bloomberg article:
“Protections have gotten
so lax in the $1 trillion market for U.S. leveraged loans that if an offering
comes with decent covenants, lenders take it as a sign that something’s wrong
with the deal.
“You do have to think
twice when you see a loan with a covenant these days,” says Thomas Majewski,
managing partner and founder of Eagle Point Credit Management.
It’s not a crazy
assumption in a market where 75 percent of new loans are now defined as
“covenant-lite,” meaning a company could, for example, rack up as much debt as
it wants regardless of its performance. In such a lenient atmosphere, the
reasoning goes, a loan must be a stinker if a borrower has to resort to
promising even standard protections.”
Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants
Speaking from a common sense viewpoint, one could (and
perhaps should) find it alarming that investors continue to eat up leveraged
loans which come with increasingly fewer protections for investors. The
phenomenon is not limited to the United States, either – in Europe, “cov-lite”
loans have emerged as a popular security for those searching for income –
despite a different name, the concept of less protection for investors is the
same.
Moody’s, which publishes its Covenant Quality Index, has
also noted the decline in protections for investors.
Figure 4. Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants
Another
quote from the aforementioned article, this time from a Moody’s executive, once
again strikes a risk-averse investor as quite alarming.
“ “It’s basically the
worst it’s ever been in terms of loan covenant protections,” says Derek
Gluckman, senior covenant officer at credit-rating firm Moody’s Investors
Service. And that includes the heady pre-crisis year of 2007. ”
Conclusion
It is
a sense of dread that many may have felt when looking back on the subprime
mortgage industry after it succumbed during the financial crisis. Back then,
investors were also hunting for extra income, and the issuance of such
securities seemed to benefit all parties involved: the issuer, underwriter and
trader for the associated fees and profits, and the homeowner for getting a
home. But, of course, it all came crashing down when those investors began to
realize just how deteriorated the subprime loans have become.
It is important to distinguish
between the subprime crisis, which was severely exacerbated by a lack of
regulation and truly abhorrent lending practices, and this concern over riskier
sections of the fixed income market. It remains to be seen how these
deteriorating leveraged loans and high yield corporate bonds will fare when
(not if) financial conditions begin to tighten. The Federal Reserve is expected
to once again increase interest rates next month, and gradual tightening of monetary
policy is also expected through the Federal Reserve’s balance sheet tapering.
While it remains plausible companies are able to rein in the weakest links of
such deteriorating credit instruments, history tells us it’s far more
appetizing for both the corporation and the investor to put profits first and
handle the consequences later.
