We straddle the line between risk and reward every day, running a personal theorem to make both minute and major decisions. In the investment world, risk is at the epicenter of portfolio construction. You need that income, or want those outsized returns, but at what cost? If you pursue the appropriate strategy and structure, actively investing in today’s corporate credit markets may offer attractive risk-adjusted return potential.
Why corporate credit remains attractive
Traditional bonds are posting yields that won’t sustain many income strategies. The 10-year Treasury is sitting well below two percent, and a popular corporate bond benchmark is yielding 80 basis points less than a year ago. Just as rich equity valuations may cap outsized returns, bonds are not delivering enough income to meet income needs. More importantly, regulatory changes enacted post-financial crisis have drained the liquidity from the markets needed to facilitate an orderly flow of buying and selling, which could result in a sudden gaping of values in the next downturn.
Curbing volatility, preserving capital, and building a portfolio reliant on late-cycle income may require broader diversification into corporate credit. Leveraged loans and high yield bonds are currently offering yield premiums of 377 and 357 basis points, respectively as of 6/30/19, compared to corporate bonds. It’s an attractive reward for older investors in need of monthly or quarterly checks, as well as younger investors trying to maintain some modicum of positive returns through the next downturn. That premium does come with underlying risks, mainly stemming from signs of strong excess building over time. As we take you through a few of these risks, be sure to take away how active management may be best positioned to help you straddle the line.
Will a flood of new issuance cause a chasm
Today’s public below-investment grade corporate debt market sits at an all-time high of $2.5 trillion, and boutique direct lending managers are sitting on nearly $149 billion of capital to lend to middle-market companies, according to Preqin. This new capital flow has replaced the pre-Recession lending paradigm once dominated by traditional banks. Collateralized loan obligations (CLOs) hold a lot of this debt, often utilizing significant leverage and facing strict credit ratings tests. In a downturn, many of these CLOs will be forced sellers of loans (to maintain compliance with docs), but we expect liquidity will be limited.
Middle-market companies continue to take on leverage
U.S. middle-market companies have enjoyed a resurgence during this lengthy economic expansion. Their leverage profile has climbed along with earnings – an acceptable scenario during periods of growth that also indicates a vulnerability if corporate earnings start to slow late cycle. These companies could face a range of idiosyncratic headwinds outside of a broad-based contraction, from customer loss to inflation pressures. Interestingly enough, leverage multiples would be even higher if not for the preference to include proforma earnings adjustments that reflect higher earnings and stronger credit profiles at the time of debt issuance.
Many bond and loan ETFs typically invest based on a market cap weighting that favors companies with the most debt, leaving investors significantly exposed to debt-laden, less creditworthy issuers. So in theory, as leverage increases, the risk facing these passive strategies may also increase. Active managers, however, tend to implement strict leverage screenings, and have a much larger universe of non-indexed securities to choose from.
The deterioration of typical capital structures
Risks in middle-market lending also include the breakdown of a typical capital structure. Senior lenders are making a habit of satisfying a borrower’s entire capital needs, an easier pill to swallow with the abundance of private market dry powder waiting to invest. Without subordinated positions, plus weaker loan covenants, first-lien positions are may face greater risks … with a big BUT.
We caution that first-lien is still the best place to mitigate default risks. If default rates were to rise, and all indications point to below-average defaults in the short term, equity and subordinate positions would first take it on the chin. Also, aside from bankruptcy, we do believe a swath of investment grade positions will be downgraded and absorbed into high yield during the next downturn. While investors in active strategies may see a greater opportunity set in the below-investment grade universe from any fallen angels, those in corporate bond ETFs may face difficulty. Many passive strategies have investment-grade mandates, which could trigger forced selling into a downturn, pressuring investment values.
The liquidity well has run dry
Credit market dislocations aren’t caused by credit defaults, but rather from the need for liquidity from existing debt holders. We discussed how CLOs may dump underperforming credit positions just as daily liquid funds are motivated to sell as a result of investor redemptions. Yet, they are selling into the Saharan desert. Public market liquidity as measured by dealer capital has plummeted from $26 billion in 2007 to just $2 billion at the end of Q1 2019, according to Credit Suisse. With few buyers facing the rating constraints hindering CLOs, the pricing dislocations could be stark.
Again, this risk highlights the differences between passive and active strategies in this environment. Passive funds may hit substantial liquidity issues in the next downturn, while active strategies with limited liquidity could potentially take advantage of forced sellers. However, not every active strategy is built from the same blueprint. Make sure you are monitoring late-cycle CLO exposure. As illustrated above, CLOs are strictly disincentivized from holding downgraded or defaulted loans, which could trigger a similar forced sell-off and a permanent loss of investor capital in some actively managed funds.
The best path to balancing risk and return
Corporate credit remains an attractive option for core fixed-income investors focused on riding out the cycle on the back of consistent income and diversified risk. When actively managed in a fund structure with limited liquidity, corporate credit may generate significant yield premiums to traditional bonds with minimal credit risks and none of the liquidity risk facing daily liquid funds during the next downturn.