Credit spreads have compressed to cycle lows, while covenant quality erosion has hit cycle highs. The rise in covenant-lite bonds exemplifies how much the credit market has shifted bargaining power to the borrowers instead of the creditors in this mature phase of the credit cycle.
Functioning like traction control in modern cars, covenants are aimed at keeping the issuers’ creditworthiness on track by limiting (or preferably reducing) net debt to EBITDA, capital expenditures or interest expenses as a proportion of income. These safety measures for credit investors are now becoming scarcer in parts of the junk bond market as shown in the graph.
On the face of it, the road ahead does not seem to be getting slippery at all. After all, the global recovery has firmly taken root, producer confidence metrics have surged recently and overall market sentiment is upbeat. It is logical that positive economic data has partly taken away investor concerns about the future of the business cycle as EBITDA and interest coverage are trending up, requiring less compensation for taking on credit risk. Who needs traction control anyway?
So investors have decided to keep the traction control mostly switched off. According to Moody’s, 40% of the global high yield market now consists of covenant-lite issuers. It has happened far too often this cycle that investors have been burned by betting on a crashing credit market and or suddenly capitulating by entering the market from the long side. Betting against beta has become too painful. This ‘go with the flow’ behavior is not uncommon in a late phase in the credit cycle, perhaps out of fear of missing out.
A closer inspection of the credit market shows that there are risks on the horizon, despite a favorable outlook for corporate earnings. Central banks in developed markets are gradually moving away from quantitative easing to quantitative tightening. This brings about a landmark shift in orientation as market participants will have to start guessing what central banks will sell instead of what they will buy. Of course, central banks will have no incentive to unsettle markets and will prepare market participants for this new episode to the best of their ability, but even if forward guidance is executed flawlessly, there’s no guarantee it will have the desired effect.
Moreover, the impact of misfiring central bankers is aggravated in a low credit spread world. Another credit-unfriendly development could be brought about by increased capital expenditure spending now that capacity utilization rates in the global economy have increased and CAPEX intentions are rising.
It is not unthinkable that the global cyclical upswing will sustain spreads and cause them to grind even lower well into 2018. Sustained profitability in an environment of rising rates would then still favor high yields compared to investment grade bonds. But with yield-hungry investors gearing up to harvest every last bit of credit risk premium in a market that is already tilting towards covenant lite, the impact of an accident in the junk bond market could very well be rising.
Mounting risks and falling spreads indicate we are already playing into extra time. This period of extra time could end up being less rewarding from a risk-reward perspective than the enjoyable start would suggest. Yes, initially, the road ahead will be clear, but what will happen miles down the road is unknown.
This article forms part of the Robeco 2018 outlook entitled Playing in Extra Time.