Leverage facilitates growth; until it doesn’t

We think the US will be able to avoid a recession next year, in the absence of a negative exogenous shock, e.g. escalation of trade wars, oil price spike etc. Accommodative monetary and (potentially) fiscal policy should extend the economic cycle to at least 2021.

Assessing recession risks in the medium-term are about what imbalances are building up in the economy. Sifting through various sectors, we are most concerned about the rising corporate debt in the US. Non-financial corporates have levered significantly since the global financial crisis, taking advantage of low borrowing costs and ample liquidity. Where the need for capital expenditure (capex) has been weak, corporates have used this cash to fund buybacks, dividend pay-out and merger and acquisition (M&A) activities.

Both investment grade (IG) and high yield (HY) corporates have increased leverage over the past decade. Net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) ratios for US IG and HY corporates have risen to the highs of the early 2000s. HY corporates have de-levered over the past couple of years, while IG corporates continue to increase their liabilities. Despite higher leverage, US credit markets have remained an attractive asset class throughout the economic cycle given the compression of credit spreads and higher yields relative to sovereign bonds. Higher leverage has been overlooked, even encouraged, as interest costs remain low and interest coverage ratios look healthy.

Fig 1: US corporate debt as a percent of GDP has risen to all-time highs¹

Fig 2: Leverage ratios for HY corporates have declined moderately while those for IG remain elevated²

Credit rating agencies have responded to the increased leverage through credit downgrades. Nearly 50% of the US IG index now comprises of corporates that are rated BBB, one notch above junk, versus 35% in 2008. In other words, the overall credit quality of the IG index has deteriorated significantly; and yet, yields have continued to decline, compensating investors less for much higher risk (see Fig 3). In contrast, the quality of the HY index has improved over the same time with over 50% of the index comprising BB-corporates (one notch below investment grade).

Fig 3: The quality of the US IG index has deteriorated significantly since 2008³

While low interest costs are a fair argument in favour of higher leverage, it is a cushion if profitability is steady. US corporate profit margins have expanded healthily in this economic cycle, which has facilitated corporates to take on more debt. If profit margins compress and profitability declines, interest cover ratios and net debt/EBITDA ratios would look worse than they currently are, even without the corporates taking on more leverage (a concept known as “passive releveraging”). This would lead to further credit downgrades and the risk of “fallen angels” with corporates slipping out of the IG space into the HY space. Credit funds may face redemptions and mark-to-market losses could be large. According to a recent article by Moody’s, the downgrade risk is not specific to the US. The quality of the global IG index has also deteriorated significantly. ⁴

Fig 4: Non-financial corporate profit margins are at all-time highs in the US⁵

Of the USD 10 trillion of non-financial corporate debt, USD 5.6 trillion consist of corporate bonds (both IG and HY). More recently, corporations have substituted bond issuances for bank loans. Bank loan issuances grew by nearly 20% year-over-year in Q1 2019 vs 2.6% for corporate bonds. In particular, leveraged loan issuances have surged, largely driven by excess liquidity and low borrowing costs. Leveraged loans are loans that are extended to companies that already have a high leverage ratio and weak credit ratings. They come higher in the pecking order of seniority of debt when compared to corporate bonds but are nevertheless risky assets for the US banks.

There are several aspects of the leveraged loan market that are concerning:

• Large market: The current market size of the leveraged loan market is USD 1.2 trillion (more than 10% of total outstanding US corporate debt). This is as large as the US HY market.
• Held by asset managers in the form of securitized products: More than half of the leveraged loans are packaged into Collateral Loan Obligations (CLOs) by banks and sold to asset managers seeking yield enhancement. Total CLOs outstanding in the US market is around USD 600bn. Most of the products are held by loan mutual funds, insurance funds and pension funds globally. The demand for CLOs has been strong over the past few years and the asset class is becoming more institutionalised given the growth of specialized loan-oriented mutual funds, albeit still less liquid than high yield bonds. Total assets under management (AUMs) of loan mutual funds/ETFs has grown 10x over the past decade to USD 200bn in 2018.⁶ One characteristic of the CLO which makes short-term “investor runs” less likely is a lock-in period, typically 2 years from issuance, wherein early redemption is not permissible. Unlike CDOs which were concentrated in the financial system, ownership of CLOs are more widespread. One might argue that a well-diversified market and technology that helps screen data reduces the probability of contagion. We think this will not matter when you are in a liquidity event leading to the disintegration of loans. Having said that, we believe that the contagion risk is not as high as the CDO events during the Global Financial Crisis.
• Low quality borrowers: According to the US Federal Reserve, over 40% of the new loans in Q1 2019 were given to corporates with debt multiplies of greater than 6x. An exogenous shock that hurts profit margins of these borrowers could lead to increased default rates, fund redemptions and mark-to-market losses. Indeed, almost 35% of the corporates in the Russell 2000 index reported negative earnings growth in the latest quarter.
• Weak covenants: Nearly 80% of leveraged loans issued since the Global Financial Crisis (GFC) have fewer investor protections and lower loss-absorption capacity vs 30% in 2007.⁷ If the economic slowdown continues and borrowers default, investors and banks will be left with little protection triggering fund redemptions and tightening financial conditions.

Most CLO investors and traders are not as concerned about the rising leverage and CLO market, as they argue that interest costs are still very low and interest coverage ratios of corporates have improved. Combined with the US Federal Reserve and European Central Bank cutting rates further, corporates are unlikely to run into debt serviceability issues even if profits weaken slightly, according to investors. While its true that interest coverage ratios are indeed high, this is against the backdrop of cycle-high profit margins. We think the left tail risk is quite fat, and if profits decline considerably amid a recession, low interest rates will not be enough to prevent defaults. There is much further room for profits to decline, than for the already-low interest rates to fall further. And even if interest rates do fall, credit spreads may blow-up, more than offsetting the decline in floating rates.

In a recent speech, Fed Chairman Jerome Powell noted that the elevated corporate debt levels do not present a risk to financial stability for now, but if the economy weakens, “overly indebted firms could well face severe strains”. The Fed notes that the banking system is better capitalised versus the GFC, and therefore the magnitude of the impact may be smaller. We view this as a mitigating factor that may prevent another recession as deep as the GFC, but it still has the capacity to wipe out a significant portion of banking capital. On CLOs, the Fed’s May financial stability report concludes that “it is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress”. Powell emphasized the importance of researching more on the impact of economic slowdown on CLO markets.

Imbalances and risks in US corporate debt and the leveraged loan market warrant a cautious approach in allocation of capital to credit markets. While corporate bonds are a good investment outside of a recession given the yield pickup versus sovereigns, careful risk management is crucial in ensuring drawdowns remain limited. We expect US and global growth to slow but accommodative monetary policy to prevent an economic recession in the next 12 months.

In this scenario, investments in US HY bonds remain attractive but be wary of US IG given high leverage, and risk of “fallen angels” as growth slows. Nonetheless we believe US IG risk premium is underpriced. Having said that, we will continue to track if recession probabilities increase and profit margins compress further. We will also monitor default rates and fund redemptions related to leveraged loans and CLOs.