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November 10, 2013 6:59 am
The credit cycle is characterised by a “gradual shift from vigilance to recklessness in lending and borrowing”.
This comment was made by Jim Grant, founder and editor of Grant’s Interest Rate Observer during the heyday of the 1980s buyout boom. Mr Grant, whose publication celebrates its 30th anniversary this year, noted another feature of the cycle on the same occasion, namely that the quality of credit deteriorates as its quantity increases. Although much water has flowed past Wall Street since these words were written, the credit cycle is unchanged.
Anyone who doubts this statement should take a look at the world of leveraged finance.
The largest leveraged buyout in history is on the verge of bankruptcy. TXU, which now operates as Energy Future Holdings, was acquired in 2007 for $45bn in the frenzied final months of the late great credit boom. Those were the days when underwriting standards had reached rock bottom, “cov-lite” entered the lexicon of Wall Street, and loans of dubious credit quality were repackaged into complex “investment grade” securities, tranched and sold on to yield-chasing investors.
A naive observer might expect that the global financial crisis would have put paid to such practices. But “never again” is not a maxim of Wall Street. Here bankers operate under a more pragmatic rule, best described as “when the ducks quack, feed them”. The current era of permanently low interest rates has made the ducks hungrier than ever.
Investors are desperately seeking income. Leveraged loans and high-yield bonds fill the bill. This year, for the first time in history, more than $1tn worth of such securities will be issued, according to JPMorgan, the bank.
These risky loans and bonds are sold to retail investors through mutual funds and exchange traded funds, which have witnessed record inflows this year.
They are packaged into collateralised loan obligations, which offer the buyers of equity tranches the prospect of a double-digit yield. Underwriting standards are deteriorating. Covenant-lite loans – that is, bank loans without restrictive covenants intended to protect creditors – accounted for around half of all new issuance this year. In the heady days of 2007, the cov-lite share of new issuance peaked at a mere 25 per cent.
Demand for leveraged loans has been so strong that around one-third of new issues this year have been “repriced”, providing borrowers with even more favourable terms. Private equity firms are using the buoyant credit markets to extract cash from their buyouts. The first three-quarters of this year witnessed a record $60bn worth of so-called dividend recaps, according to Standard & Poor’s Leveraged Commentary & Data, a research group.
A recent paper* by Robin Greenwood and Samuel Hanson looked at the share of high-yield bond issuance relative to total corporate bond issuance back to the 1920s. The Harvard Business School professors found that a decline in issuer quality is a robust indicator of credit market overheating. In fact, issuer quality turns out to be a better indicator of overheating than rapid credit growth alone, although the two are positively correlated. Mr Greenwood tells me that “all signs suggest that issuer quality is pretty poor at the moment”.
Still, on several measures credit conditions do not look quite as overheated as in the years before Lehman’s bust.
Steve Miller, managing director of Leveraged Commentary & Data, estimates that the implied default rate on leveraged loans remains above the historic average default rate. Buyouts are not as supersized as in the days when TXU was taken private. Nor has leverage reached such nosebleed levels.
In 2007, roughly one-third of LBOs were leveraged at seven or more times earnings before interest, tax, depreciation and amortisation. In the year to the end of September, fewer than one in 20 LBOs were laden with so much debt.
While the absolute yields offered by high-yield bonds and leveraged loans are at a low point, relative valuations are not too bad. The spreads on leveraged loans remain above average. Leveraged loans are still priced to deliver moderately positive returns over Libor. The expected returns for high-yield bonds relative to government bonds are not yet negative, as was the case during the credit-bubble years.
While the world of leveraged finance is beginning to look frothy, general credit conditions in the US remain extremely accommodating.
The balance sheet of the US banking system is liquid. Corporations are generating lots of cash and in aggregate are running a financial surplus. The housing market is recovering but not yet in bubble territory. As long as interest rates remain at record lows, the cost of debt service is well below average. And as long as inflation remains quiescent, the Federal Reserve is not under any strong pressure to take its foot off the gas pedal.
The prospects for investors in US credit look poor today. But they are likely to get even bleaker before this cycle finally turns.
*Greenwood, Robin, and Samuel G. Hanson. “Issuer Quality and Corporate Bond Returns.” Review of Financial Studies 26, no. 6 (June 2013)
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