A sharp drop in credit markets in late 2018 made many wonder whether the fat years are coming at an end. Where are the soft spots in the credit mountain in case of a bear market? Who carries the risk? How will the market deal with the gargantuan workouts ahead if things go pear-shaped? Kat Van Hoof reports.

WORKOUT

The issuance drought and valuation plunge of late 2018 was felt across credit categories, from investment grade to high-yield bonds and leveraged loans. The losses from the wobble were partially recouped in January 2019, but the market is still on edge. As of late February, year-to-date issuance was subdued for bonds and loans at just over $9bn, compared with $40bn over the same period in 2018.

Counterintuitively, the shock helped keep the credit ship afloat by triggering cautionary measures. After a relatively aggressive set of four interest rate hikes in 2018, US Federal Reserve chair Jerome Powell changed the mood music to a more dovish approach for the rest of the year. Corporate bond yields will likely remain attractive over Treasuries as investors and issuers still have access to cheaper debt. This delicate period of enough growth to keep the cogs turning, but enough bad news to keep monetary policy supportive, is often referred to as a ‘Goldilocks scenario’. But the bear has shown its teeth once already; what happens if it comes out of hibernation fully?

US-style litigation 

Most of the anxiety in corporate credit markets centres around private debt, including leveraged loans, rather than publicly traded debt. The abundance of ‘covenant-lite’ paper that has been printed in 2017 and 2018 makes it more difficult to see what is around the corner – workouts in case of the anticipated downturn could be epic. “Companies have more leeway to put off judgement day,” says Manny Grillo, a partner in law firm Baker Botts’ bankruptcy group. In the last credit crisis, banks carried the greatest risk, but strong regulation has curtailed their debt exposure. “This time it is investors that are the more exposed,” says Mr Grillo.

“If the economy stalls significantly, we are likely to see some of the most complex workouts we have seen so far,” says Simon Baskerville, global co-chair of the restructuring and special situations practice at law firm Latham & Watkins. He expects a lot more US-style debt-related litigation regarding European restructurings being played out in the UK and the US courts in the coming years. An increasing number of US investors have been coming into the UK to litigate cases; across the Atlantic, companies can file for bankruptcy under Chapter 11, which involves restructuring of the debt.

“Loan documents formulated in the US are now being used for financings of pan-European groups, which have a patchwork of different jurisdictions and laws. This is raising the potential for disputes between lenders, and between lenders and borrowers, that have not been seen before,” adds Mr Baskerville. This trend has gone hand in hand with the rise of US law firms establishing a presence in London, litigating US law. “Europe and the UK are looking at introducing Chapter 11-like bankruptcy laws, but no such comprehensive legislation is in place yet,” says Mr Baskerville.

As loans clauses increasingly favour private equity sponsors – stripping away investor protections – debt buyers have struggled to keep pace. Nevertheless, buyers continue to line up for this type of paper and borrowers are happy to provide more product. Market dynamics and regulation shifted profoundly after the last financial recession, leading to an enormous wave of – sometimes irresponsible – corporate lending and borrowing.

The house QE built

After the financial crisis, central banks across the globe used quantitative easing programmes to stimulate economies. As they bought up government and corporate bonds, demand in credit markets ballooned. Simultaneously, interest rates were brought down to record lows, encouraging issuance of cheap debt and driving investors to corporate bonds in their hunt for yield; excellent conditions for higher corporate leverage, according to Vishy Tirupattur, head of US fixed-income research at Morgan Stanley. “Corporate leverage ratios are at or near all-time highs,” he says, adding that this is the case across loans, investment grade and high-yield bonds.

“Corporate credit has become more systemically important than it was,” says Torsten Slok, chief international economist at Deutsche Bank. The market has become more vulnerable and sensitive, but the situation is less dramatic than with the previous credit crunch.

Investors have been willing to buy more debt at a higher debt to the earnings before interest, taxes, depreciation and amortisation (Ebitda) ratio than in the past, and the worst offender is leveraged loans. Although they are sub-investment grade and at floating rates, loans are attractive to investors because they are often more senior debt than bonds, which are typically unsecured, according to Mr Grillo. Most borrowers have both and though loans are issued for a fixed term, when an issuer comes up against a bond maturity, this is often a catalyst for senior loans to be refinanced.

All three credit categories grew exponentially post-crisis, but leveraged loans had the steepest growth curve. Sponsor leveraged buyouts (LBOs) – whereby a private equity firm buys a company and levers it up with debt to pay for an acquisition – are the “most aggressive part of the market”, says Richard Zogheb, Citigroup’s head of debt capital markets. If there is to be a real correction of the credit market, this is the first place where it will be felt.

After an LBO, leverage often exceeds seven times Ebitda, which has likely been heavily adjusted. So long as interest rates remain low, most private companies can carry their debt burden and debt investors are happy to buy. This high-risk, high-return asset has done very well in recent years, but if interest payments go up or if sentiment turns, the chances of a material sell-off are high, according to Mr Zogheb.

Despite the continuation of loose lending policies, some cautionary tales provide insight into what happens if leveraged loan defaults go up. US toy retailer Toys R Us struggled with annual interest payments of $400m on its $5.2bn debt burden, a hangover from an LBO by three private equity funds in 2005. Investors bought into a $600m bond offering in 2016 to push out debt maturities, but the retailer failed to stave off bankruptcy in late 2017.

Covenant-lite heavy lifting

How could the market so fundamentally misjudge the situation? The answer lies in an alarming trend: covenant-lite paper. Ravenous demand for leveraged loans not only fuelled huge supply from sponsors, which financed acquisitions with ever greater proportions of debt, it also allowed private equity firms greater negotiating power on aggressive terms and, crucially, on loosening covenants. “Moody’s measures of covenant quality are at historically low levels, in several cases worse than they were in 2008,” says Mr Tirupattur.

Covenants act as a cushion for debt investors: fully covenanted loans must continuously comply with certain terms or the debt automatically goes into default. These guardrails allow investors to catch problems early and force a company to take action. Covenant-lite loans only need to be in compliance with the terms under certain conditions, for instance, when the company adds more debt or initiates any merger and acquisition activity. “Today, more than 80% of all loans are covenant-lite, compared with about 25% pre-crisis,” says Mr Tirupattur.

The danger is not so much the risk of defaults, which are still very low, according to Mr Zogheb. “During the crisis, sponsors added covenants when necessary. Leverage was more of an issue than the covenants themselves,” he says. Rather, the problem lies more in the lack of visibility of trouble ahead, according to Mr Baskerville, who says: “In case of an issue or a downturn, loose covenants mean it takes longer for alarm bells to ring and the lenders to be brought to the table to seek a solution.”  

For public debt, it is easier for bond holders to coordinate and create catalysts for formal restrictions. Defaults may be low at present, but Mr Zogheb also expects the rate to pick up as the economic backdrop changes. For some companies, a small deterioration in earnings can have a big impact.

Workout regimes

A large number of sectors have had to contend with disruption from new technologies. For instance, traditional retail businesses have been hit hard by the likes of Amazon and other online retailers. There are several retail businesses which should have arguably already been restructured, but are still operational in part thanks to loose covenants. Incidentally, these businesses are perennial candidates for an initial public offering, which would pass the hot potato to the equity market.

In a bankruptcy event, senior secured loans are the first in line to be repaid and therefore have much higher post-default recovery rates compared with high-yield bonds, according to Mr Tirupattur. “However, the growing proportion of loan-only debt capital structures challenges the high recovery thesis for loans,” he says. Much of the growth in leveraged loans was cannibalised from the high-yield market.

Though some of the risk has shifted towards investors, there are still a few fixes in the arsenal to avoid large write-offs on investments. “Investors who would not get the debt paid back in full could significantly enhance recovery on their investment if they are prepared to take a debt for equity swap,” says Mr Baskerville. Mr Grillo agrees, saying loan-only structures are quite rare and that in these cases investors are aware they will need to take equity if things go wrong.

Furthermore, both say there is a huge and very liquid pool of capital hunting for distressed debt to buy at a discount. “The lack of supply is actually keeping prices of lower quality debt up,” says Mr Grillo. There are more hedge funds than ever chasing distressed debt. Barclays head of European bond syndicate Marco Baldini says: “It’s a feature of how good the market remains that everyone wants a bit of the action.”

A more worrying feature of the market is the proliferation of electronic trading. “Due to regulatory intervention, a lot of liquidity has moved from physical market makers to machines. Huge swings that have not been driven by actual investment decisions are not helpful. It leads to random price action and exacerbates volatility,” says Mr Baldini.

Collateralised damage  

Much of the leveraged loans frenzy involves collateralised loan obligations (CLOs). A CLO packages a large number of loans to spread the risk, but the market was told the same story about assets such as credit default swaps  and mortgage-backed securities before 2008. “Securitisation can be a powerful risk management tool thanks to its inherent diversification, but the rapid increase in CLOs is a bit worrying,” says Mr Zogheb.

During the crisis, almost all CLOs held up well and the market has grown exponentially since then, to about $3000bn from around $600bn in 2007. There is a lot more transparency about this type of investment now and in theory it should do well in a downturn, but the new metrics of CLOs are untested, Mr Zogheb cautions.

However, Mr Grillo says: “Most of the exposure is to the shadow banking market, so the risk is much more widely spread than during the banking crisis and recession.” A disadvantage of less corporate credit on bank balance sheets is that it curtails liquidity in the case of big market sell-offs.

The CLO market has become more sophisticated over the years. In fact, the appetite for CLOs has stimulated more restructurings of privately owned businesses that are fundamentally too levered up. “Covenant-lite loans include large baskets that allow for the layering of new cash,” says Mr Baskerville. This fresh capital is not without strings, however, allowing the new money lenders to get better terms, economic protections and an enhanced intercreditor position if things go wrong. “There is a new world of restructuring, using the rules to engineer solutions,” he adds.

Triple jeopardy

Private markets are more opaque than publicly traded assets, which naturally inspires nervousness. Yet, the investment grade and high-yield markets are not without their vulnerabilities. Investors may be more sanguine about these bonds exactly because they seem more transparent, but this market has soft spots of its own.

Investors and bankers alike breathed a sigh of relief when AB Inbev’s came to market with $15.5bn-worth of bonds in January to refinance some of the debt taken on during the 2016 SABMiller takeover. The issuance was well received after a long drought at the end of 2018. Only in December, rating agency Moody’s had downgraded the $120bn market cap company to BBB status, a whisker away from junk. The brewer’s $100bn debt mound was cited as the reason for the negative ratings action.

Prudent refinancing action, some would say, but others have suggested that the deal shows unease about the credit market. “AB Inbev paid up to sleep well at night,” said one US-based investment banker, claiming it acted sooner than was necessary and risked paying a higher premium than strictly necessary. It is unlikely the company would have even contemplated such a deal even a year ago, the banker claimed. AB Inbev is not the only company keen to protect its investment grade status: others include General Electric, Ford, Lowe, CVS and PG&E.  

“The share of the non-financial BBB rated bonds has tripled over the past decade, creating a potentially systematic vulnerability in case of downgrades,” says Mr Tirupattur. Morgan Stanley has looked at the magnitude of downgraded investment grade names over the past few cycles and the potential for downgrades is much larger in this cycle. “This could create a digestion problem for the high-yield bond market,” adds Mr Tirupattur.

A much less visible trend is the shift in ownership of US credit. Over the post-crisis years, foreign ownership increased from 22% to near 30% of US corporate debt holders. Many of these were strictly interest rate investors looking at institutional bonds. But as interest rates went painfully low, these investors saw investment grade corporate credit as a higher yielding proxy for Treasuries. “These investors are not used to holding corporate bonds and may not be ‘strong hands’ in periods of volatility,” says Mr Tirupattur. These are not the steadiest fingers on the trigger of lower rated investment grade bonds.

Mr Zogheb agrees that after leveraged loans, a potential increase in ‘fallen angels’ from investment grade to junk is a soft spot in the credit market. But he is less convinced that the issue could be systemic. Many corporates are more comfortable than ever in the BBB spectrum and it would take a lot of downgrades in a very short space of time to create a big problem. “During the crisis, Ford was downgraded to junk status. There was some forced selling, but many investment grade investors stayed or used their high-yield funds to buy up the debt, because they believed it would just be a temporary stop, which it was,” says Mr Zogheb.

Many of the speculative grade companies have a great number of defence mechanisms at their disposal. GE in February 2019 agreed the sale of its life sciences business to Danaher for $21bn, which would give it more than enough to cover $14bn of upcoming debt commitments in the next two years. But investors are losing patience with repeat offenders. US chemist retailer CVS loaded up on debt in a series of acquisitions, but in 2018 promised shareholders to bring down the debt to Ebitda leverage to three times within two years. Currently, the ratio has gone up to above five times.

Credit outlook

For the gloomiest outcomes to happen, there must first be a significant and sustained downturn. While the interviewees agreed that the cycle is coming to an end, it is more likely to conclude in a contraction rather than a real recession or crunch. The jury is still out on when conditions will start to really bite, with forecasts ranging from late 2019 to well into 2020.

“Credit markets will continue to perform okay as the economy does okay,” says Mr Slok, who adds that “demand for US credit is lower and more sensitive than it was to a slowdown in the economy, expected in a year or two.” There are signs that the cycle still has a bit longer to run. There was a marked release of pressure after the Fed message that it would not raise rates in the near term, according to Mr Grillo. However, should interest rates on risk-free assets start to rise again, corporate credit would underperform, Mr Slok warns.

A bigger issue than demand in 2019 may be supply. Merger activity, a great driver of primary debt issuance, has been subdued. Valuations may come down if short-term volatility flares up. Credit markets have become more ‘stock picker’ territory, so it is likely that mid-market deals and cyclical sectors will be less attractive. Sectors such as building products, heavily commodity-driven sectors such as chemicals, metals and mining, as well as consumer retail, will have to maintain modest leverage.

It would seem that this is not the time to hunt for yield, but rather to invest in higher rated debt. Financial and bank debt is a notable exception to the high leverage trend. Banks are very well capitalised now, making US bank debt in particular attractive, according to Mr Tirupattur. Rather than the old adage 'buy the dip', investors should ride the dip and use the rallies to upgrade debt portfolios. 

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter