INSIGHTS

“Most of the people I speak with today tell me they’re unusually uncertain about what lies ahead in terms of the economy, central bank behavior, fiscal management (or lack thereof), politics, and geopolitics, and what it all means for the markets. It’s very healthy that they acknowledge their uncertainty. And it’s true that the outlook is as unpredictable as ever, if not more so.”

–  Howard Marks, recent market outlook for clients

The market rally that began roughly five months ago recently stalled, primarily due to stickier-than-expected inflation and indications that the U.S. may get two or fewer interest rate cuts in 2024, as opposed to the six investors were pricing in earlier in the year – risks we highlighted in January when we noted that “the prevailing market narrative for the coming year demands a level of optimism that may be bordering on credulousness.” However, if we zoom out, it’s evident that equity and leveraged credit markets aren’t anywhere near levels that would denote a significant increase in risk aversion. (See Figure 1.) High yield bond spreads are still hovering around the low end of their normal range, over 35% of U.S. leveraged loans are trading above par, and the S&P 500 Index is up over 20% in the last 12 months.¹ How does one square the robust performance we saw in the five months through March with the uncertainty that our co-chairman Howard Marks is describing above? And should credit investors expect the recent market stumble to turn into a more pronounced decline?

Figure 1: Equity and Leveraged Credit Markets Have Enjoyed a Robust Rally Over the Last Year

Source: S&P Global, ICE BofA, as of April 18, 2024

While multiple forces put upward pressure on securities prices in recent months, we believe supportive technical factors – especially the high level of liquidity in the global financial system – were a major driver. These technical tailwinds are unlikely to dissipate in the next few quarters; however, we think countervailing headwinds could also be strengthening, given the cracks that are emerging in the balance sheets of overleveraged borrowers and overextended consumers. In this “unusually uncertain” environment, we believe pockets of weakness are likely to continue appearing, even if average economic and corporate fundamentals remain healthy. Thus, there’s liable to be greater dispersion between industries, sectors, and issuers in the coming year. In short, we believe it could be a very good time to be an active credit investor.

TOO MUCH MONEY CHASING TOO FEW BONDS AND LOANS

In recent months, leveraged credit markets – both public and private – were buoyed by the high level of liquidity in the financial system, a consequence of the torrent of cash that flooded the economy and investment accounts over the last four years as a result of massive fiscal stimulus and money creation. Interestingly, while the Federal Reserve has been engaging in quantitative tightening (i.e., shrinking its balance sheet) for more than a year, bank reserves have actually increased slightly over this period.² This is largely because reverse repo balances, not bank reserves, have been declining. This is notable because in 2022 and early 2023, banks reduced their lending activity in anticipation of a large drawdown in bank reserves. This never materialized, so banks have consequently been ramping up lending in recent quarters. What this all means is that there’s been a tremendous amount of capital seeking investment.

One asset class that has attracted significant attention has been the U.S. high yield bond market, which saw inflows of nearly $20 billion in the five months through March 31.³ Investors who eschewed the asset class in 2022 and throughout much of 2023 were likely drawn back in because they can now:

• lock in prospective yields in the high single digits;
• extend duration at a time when additional interest rate hikes are unlikely; and
• create a portfolio of high-quality assets with limited default risk.

While the demand for non-investment grade bonds has increased in recent quarters, the supply of new bonds hasn’t grown at the same pace. The high yield bond market actually shrank by roughly $240 billion, or by over 15%, in 2022-23.⁴ It’s true that the pace of gross issuance picked up considerably in the first quarter, as a substantial number of companies took advantage of the opening in capital markets to address near-term maturities. But net issuance (excluding refinancings) in the period reached only $15 billion, well below the $300 billion seen in the investment grade bond market. (See Figure 2.) Thus, the uptick in supply in the first quarter wasn’t enough to offset the spike in demand, particularly from institutional investors. Given these dynamics, it’s unsurprising that new issues in the high yield bond market were four to seven times oversubscribed in January.⁵

Figure 2: Issuance of Investment Grade Bonds Has Dwarfed Activity in the High Yield Bond Market

Source: JP Morgan, as of March 31, 2024

A similar supply/demand dynamic has been at play in the U.S. leveraged loan market. Demand has been elevated because of the surge in the creation of collateralized loan obligations (CLOs), which hold around 70% of the U.S. leveraged loan market. Over $45 billion of new U.S. CLOs have been created thus far in 2024, roughly 40% more than over the same period in 2023.⁶ (See Figure 3.) However, despite the surge in refinancings and repricings in the loan market in recent months, the U.S. syndicated loan market actually shrank by approximately $9 billion in the first quarter and is almost $30 billion smaller than the peak in September 2022.⁷

Figure 3: CLO Issuance Has Increased Meaningfully in Recent Months

Source: JP Morgan, as of March 31, 2024

What does this mean for leveraged credit markets moving forward? While positive technicals are likely to continue putting upward pressure on loan and bond prices in the near term, we also think that market performance in the next year may be bumpier than it was in the prior 12 months – in part because of multiple emerging risk factors.

RISK #1: OVERLEVERAGED BORROWERS

As we noted in Performing Credit Quarterly 3Q2023, average fundamentals in the high yield bond and leveraged loan markets remain fairly sound, but tail risk – especially in the public and private loan markets – is continuing to grow as companies struggle with overleveraged capital structures put in place with the expectation that interest rates would remain near zero.

Consider the changes we’ve seen in the distressed debt universe over the last few years. Oaktree’s Global Opportunities group has noted that at year-end 2021, in the universe of companies they monitor, around $30 billion of debt across roughly 40 issuers was trading at prices below 90 cents on the dollar and at yields above 15%. Fast forward to the present, and debt with the aforementioned characteristics now totals more than $150 billion across almost 200 issuers.⁸

Importantly, we’ve also seen stress pop up in unexpected places. For example, Altice France, the large telecom company, saw the price of its secured bonds drop to around 70 cents on the dollar in the first quarter and saw its unsecured bonds drop much more.⁹ This occurred because Altice unexpectedly announced that creditors would need to accept haircuts on their current instruments, after which the company’s credit rating was cut to CCC by S&P Global Ratings and Moody’s.¹⁰

This series of events surprised many investors. While it was well known that Altice had too much leverage, almost no one thought it would take such drastic measures. That’s because it didn’t fit the profile for the type of company expected to pursue a liability management exercise in the current environment:

• It’s a large asset-rich business that was thought to be well collateralized.
• It’s a European company, and recent investor concern has primarily been centered on highly leveraged U.S. companies.
• It’s not owned by a private equity sponsor. The aggressive use of leverage by sponsors in the 2020-21 period was expected to be the main driver of distress in this cycle.
• Its earnings growth had been weakening, but wasn’t slowing at a pace that would typically lead to a potential restructuring.

However, the risk assessment changes when you combine the business’s tepid performance with its significant near-term maturities and the current level of interest rates. Altice determined that its financing costs would be unacceptably high at its current leverage level. Thus, management revised that leverage target lower, which meant the company needed to ask for concessions from creditors. This announcement unsettled more than just the Altice investor base. Both European loan and high yield bond markets experienced volatility in the days following the downgrade of Altice, potentially because investors who had previously thought they were holding safe instruments suddenly had to reevaluate.

RISK #2: OVEREXTENDED CONSUMERS

One of the most notable features of the economic landscape over the last year has been the resilience of the U.S. consumer. However, we’re beginning to see cracks emerge in the consumer lending market – particularly in the non-prime segment, i.e., borrowers with a credit score below “prime” but above “subprime.”

Consider the experience of one U.S. consumer loan provider that has seen its loan losses soar in the last two years – a time when U.S. unemployment has been near a 50-year low, real wage growth has turned positive, and retail sales have remained robust.¹¹

The story begins in 2018:

• Loans that the company originated in 2018 performed fairly well for the first two years, with losses of roughly 6% per year, but after the two-year mark, the performance went from “good” to “extremely good.” Loan losses dropped considerably as consumer spending slowed and Covid-19 stimulus checks began to arrive.
• Loans originated in 2019 exhibited a similar pattern: loss rates were modest until around 2020, when they collapsed.
• Loans originated in 2020 obviously benefited massively from pandemic-related stimulus, meaning losses were meaningfully lower than projected.

Now let’s turn to 2021 and 2022. Loans originated in these years were scored using a model trained on the performance of loans originated between 2018 and 2020. In other words, the model rated borrowers based on the assumption that the stimulus-fueled performance of the pandemic era was the norm. Very low-credit-quality borrowers were often mischaracterized as moderate-credit-quality. Unsurprisingly, at roughly the 18-month point, the loss rates of loans originated in 2022 were running at more than three times those of loans created in 2019.

Our market observations indicate that this situation isn’t unique to this one company or to consumer unsecured lending. We’ve seen a similar dynamic in other areas, such as auto loans, credit cards, and home improvement loans. This is reflected in buying trends in the market for asset-backed securities, structured credit instruments made up of pools of these types of loans. While ABS investors are still comfortable buying investment grade tranches, demand for junior tranches – which are much more sensitive to performance of the underlying loans – has essentially dried up.¹²

THE BOTTOM LINE

In Performing Credit Quarterly 4Q2023, we noted the high level of optimism being priced into markets. We didn’t point this out because we thought the market was set to experience a meltdown; we highlighted it because – as Howard has long said – “no matter how good the fundamental outlook is for something, when investors apply too much optimism in pricing it, it won’t be a bargain.” Moving forward, we believe credit investors should remain cautious, but also be prepared to take advantage of what could be a period of greater volatility and dispersion. As we’ve stated frequently in the last year, we believe we’re solidly back in a credit picker’s market.

CREDIT MARKETS: KEY TRENDS, RISKS, AND OPPORTUNITIES TO MONITOR IN 2Q2024

(1) High yield bond investors don’t need to rely on spread-narrowing to earn a compelling total return

Over the last six months, one question has frequently been raised by those considering investing in non-investment grade credit: “Should I buy if yields are attractive, but spreads aren’t?” To answer this question, one must consider both yields and spreads in context.

In the decade preceding 2022, the fed funds rate was often near 0%, average yields in the U.S. high yield bond market were in the 5-6% range, and the average price in the market was frequently at or above par.¹³ Thus, leveraged credit investors, for the most part, were focused solely on yield spreads. Investors needed spreads to narrow if they were to earn a total return that could compensate for the risk of buying non-investment grade credit. Fast forward to today, and the yield of the U.S. high yield bond index is near 8%, which is almost 1.5 times the ten-year average and sufficient for many investors, and the index is trading below both par and the average price over the last decade.¹⁴

One might argue that current yield spreads are insufficient compensation for credit risk. But when compared to the historical norm, credit spreads in the high yield bond market don’t appear to be overly tight. In 1Q2018, the average spread in the high yield bond market was around 330 bps; it’s currently near the same level, and average duration is lower by around one year. And quality in the high yield bond market is stronger than it was in 2018: the percentage of BB-rated issuers (the highest non-investment grade credit rating) remains near the decade-high at 48%.¹⁵ Moreover, investors in the riskiest part of the high yield bond market are demanding normal levels of additional compensation for risk: the current difference between the spread of CCC-rated bonds and BB-rated bonds is roughly 670 bps, which is within a few basis points of the ten-year median.¹⁶

Finally, it’s important to note that the current equity risk premium – i.e., the expected excess return an investor earns for investing in equities versus Treasurys – is the lowest it has been since 2001.¹⁷ (See Figure 4.) If an investor is concerned that credit spreads aren’t offering sufficient compensation for risk, why would they invest in the equity market, where the risk premium is minimal and there is no contractual yield?

In short, we believe the relative value calculus changes dramatically when spread compression is no longer needed to earn an attractive return in leveraged credit.

Figure 4: The Equity Risk Premium Hasn’t Been This Unfavorable Since 2001

Source: Bloomberg, as of March 31, 2024¹⁸

(2) Patience may once again be a significant virtue in credit investment

Patience has historically been rewarded in investing, but over the past decade – when high-quality leveraged credit was usually yielding under 5% – credit investors often struggled to justify self-restraint. Instead, many accepted weak investor protections and stretched for yield by investing in the riskiest parts of the credit markets. Few investors were punished for acting aggressively in an ultra-low interest rate environment, so the price of patience seemed too high for many.

However, this situation has changed dramatically due to the apparent paradigm shift in the interest rate environment. Today, investors in high-quality non-investment grade portfolios can earn roughly 8% yields as they wait patiently for dislocation to occur, whether that’s broad market dislocation or sell-offs impacting specific sectors or regions.

While we aren’t expecting to see a widespread crisis in the next year, we think that downside shocks remain more likely than upside surprises. In particular, we believe that we could see a meaningful repricing in many markets if the pace and size of the Federal Reserve’s dovish pivot continues to disappoint. If this occurs, investors who’ve remained patient and prioritized risk control will likely be in a good position to take advantage of market weakness. On the other hand, if the Fed doesn’t disappoint and no dislocation occurs, then these same credit investors would be holding a portfolio generating substantial income in an environment with little risk of near-term interest rate increases. In other words, the opportunity cost of patience appears to have declined.

(3) Investors should focus on long-term trends in interest rates, not short-term changes

We’ll conclude with a quote from Howard Marks’ recent note to clients:

This is a good time for me to issue a reminder that the Fed’s individual interest rate manipulations are an example of short-term events that lack long-term significance. These days, everyone wants to know how many rate cuts there will be in 2024 and in what month they’ll start. But, as I wrote in November 2022 in What Really Matters? (a memo I thought mattered but which garnered relatively little response), the answers to questions about rate cut details aren’t meaningful, as any impact is likely to disappear within a few months.

What does matter in this department is whether rates will stick in the range of 3.0% to 3.5% for the next 5-10 years, as I think, or return to the 0-2% range that prevailed most of the time from 2009 to 2021. If it’s the former, it should follow that equity returns will be lower than they were in that halcyon period; leveraged investment strategies will be less advantaged; and returns from credit will be markedly better than they were. That’s about all I can say, but it’s a lot.