What to Make of the Credit Cycle (Part 2)

In Sunday’s “What to Make of the Credit Cycle (Part 1),” we noted various takes on the credit cycle by Moody’s, Fitch, Guggenheim Partners and Frank K. Martin. In his letter to shareholders, JPMorgan ($JPM) CEO Jamie Dimon chimes in and offers a similar conclusion to that of Guggenheim Partners’ Scott Minerd. That is: there’s a good chance that interest rates will go up faster than expected. And that will have ramifications. Here’s what he had to say,

“Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal. We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate – reacting to the markets, not guiding the markets. A simple scenario under which this could happen is if inflation and wages grow more than people expect. I believe that many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think.”

He continues,

“If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing – and wages start going up, as do commodity prices – then it is not an unreasonable possibility that inflation could go higher than people might expect. As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment.”

There’s a whole industry of restructuring professionals…gulp…hoping that he’s correct. There are a number of funds raising cash right now hoping that he’s correct.

*****

Still, it’s a question of how much how fast. Wells Fargo ($WFC) yesterday indicated that a 300 bps increase in LIBOR would not immediately pressure most issuer’s capital structures. Also:

So. Yeah.

What to Make of the Credit Cycle (Part 1)

Moody's, Fitch & Guggenheim Partners Chime In

Earlier this week, Moody’s Default and Ratings Analytics team forecasted that the US’ trailing 12-month high-yield default rate will sink to 2% — from its February 2018 3.6% level — by February 2019. That is not a good sign for restructuring professionals itching for an uptick in activity.

FitchRatings chimed in as well, noting that underwriting standards underscore that the leveraged debt market is in the later stages of the credit cycle. But, it added,

“Aggressive documentation terms now prevalent could challenge recoveries in the next downturn. However, a surge in refinancing activity since 2016 should increase time between the credit cycle's bottom and peak in default rates. Looser documentation, such as the prevalence of covenant-lite (cov-lite) loans, should also lower the risk of technical default while enabling issuers to access additional funding via secured debt and unrestricted subsidiary provisions.” (emphasis ours)

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High Yield Investors May be Underestimating Tax Reform

Guggenheim Advises Caution in its High Yield & Bank Loan Outlook

2017 was a year marked by record institutional bank loan issuance ($504b, driven in part by high CLO demand) and robust high yield issuance ($276b, up 20% from '16). So, now what? 

On January 18, Guggenheim released its "High-Yield and Bank Loan Outlook." We've taken the liberty of summarizing it for you. The following highlights - edited for brevity and clarity - are Guggenheim's conclusions/observations unless indicated otherwise:

• FED Action Will End the Business Cycle. "With the unemployment rate likely headed to 3.5 percent, we think the net result will be a faster pace of Fed hikes in 2018 than policymakers or financial markets currently expect. Tighter monetary policy will, in turn, begin to put the brakes on the economy, bringing us closer to the end of the business cycle."

• A Recession is Coming in Late 2019 or Early 2020. Tightening monetary conditions in an over-levered economy will push the US into recession. See "Forecasting the Next Recession."

PETITION NOTE: If true, we very well may see job loss in the restructuring industry. Two years is an awfully long time to wait for increased volume in a world where the majority of deal flow is increasingly consolidated among fewer and fewer firms who, by extension, are the only players with pricing power. As price compression continues to afflict virtually every other professional in the stack (other than, maybe, to a lesser extent, the lawyers), something will need to give. We'd expect to see some capitulation among the financial advisory and investment banking ranks. 

PETITION NOTE 2: Notwithstanding the foregoing (and to be a little more optimistic for the industry), FOMO and the new Tax Reform legislation may just form the basis for some balance sheet action (for non-retail credits) in the near term...

• Late-cycle Credit Standards in the Loan/HY Market are Worrisome. 0% LIBOR floors + weak covenants = no bueno loans. 0% Libor floors reflect a tremendous amount of demand by investors and also suggests "that investors assign only a low probability of a recession occurring within anticipated holding periods, which is typical late-cycle behavior." Compounding matters, "[b]y the end of 2017, covenant-lite represented 80 percent of the loan market outstanding compared to roughly 30 percent just five years ago." With an average high-yield corporate bond earning only slightly north of the 10-year Treasury on a loss-adjusted basis, average high-yield investors are receiving inadequate compensation for the (liquidity and credit) risk they are taking. Notably, Moody's tracking of high-yield covenant quality "shows that we are near the worst level since they began tracking it in 2010."

PETITION NOTE 3: Demand driving the LIBOR floor down to 0% - in the face of unprecedented bank loan issuance - demonstrates how much dry powder rests within the system currently. It also demonstrates a tremendous lack of discipline in the face of FOMO and/or LPs who are undoubtedly questioning why they're paying management fees to managers when they could simply put money in high yield index funds. 

PETITION NOTE 3.1: You may want to check what's in those high yield index funds.

• Tax Reform Will Plunder the High Yield Market. "It is hard to identify just one area of weakness that will ultimately be responsible for toppling the U.S. economy into recession, but we have our eye on some fragile segments of the economy. The passage of the Tax Cuts and Jobs Act has been largely viewed as positive for corporate bottom lines, consumer spending, and business investment, but there has been less time spent analyzing the adverse effect of certain provisions within the Act. Among them is the change to net interest deductibility: Under the new bill, companies can no longer deduct all of their net interest expense from earnings before taxes are calculated. Net interest deductions are now capped at 30 percent of EBITDA, and in a few years this will become stricter with the cap calculated on earnings before interest and taxes (EBIT). Our review suggests this will affect 40 percent of borrowers in the high yield corporate bond market, and could create a tax liability for companies that previously may not have had one."

• More on Tax Reform. Tax Reform may serve as a BIGLY shock to leveraged companies. "For companies with significant debt burdens, such as those in the oil and gas industry, materials, and media, the impact of a lower corporate tax rate will likely be negated by the inability to deduct interest expense above 30 percent of EBITDA." Of 363 individual issuers of non-real estate high-yield credit with greater than $50mm of EBITDA as of last quarter, 137 individual issuers could be impacted by the new limit. The most impacted sector is energy (33 companies), followed by media, leisure and materials. The most impacted industries are utilities (8 companies, 80% of the universe), financial services (5 and 71%), and media (20 and 56%). Guggenheim predicts this may not end well for the average high-yield investor. 

PETITION NOTE 4: For all of those folks who gave us feedback that PETITION focuses too much on Amazon/retail, you very well see a lot more diversity if Guggenheim is correct about all of this.