Over the last couple of weeks I’ve been tweeting about the relentless improvement in the corporate credit markets and credit derivatives. It all started on February 16, when credit bears toying around with the Investment Grade CDX above 120bps were caught offside by a sudden $22B binge of new corporate issuance.
The rest is now history: over the following 15 trading days new corporate bonds (sales) have totaled more than $140B, and, since the derivatives can’t stray too far from their underliers, the Investment Grade CDX has plummeted to 95bps. Investment Grade spreads are also down from 200bps to 174bps, and High Yield spreads have tightened 170bps.
Virtually everyone who bought into the largest issues sold in September/October of last year, or in January/February is showing, on average, a price gain of 1.5%. Tired of hearing booming news about the credit markets? Good, because the rest of this piece is actually dedicated to items that need monitoring, lest credit watchers get too giddy.
The always insightful Adam Richmond, of Morgan Stanley, notes the following:
- The voracious appetite for corporate bonds is now highly concentrated in the Investment Grade space. Only $21B of HY corporates have been sold so far this year, and the last 6 months of 2015 tallied a paltry $92B;
- Gross leverage at Investment Grade companies is back at decade’s highs;
- EBITDA growth excluding energy was a modest 4% in Q4 of 2015. Including energy it was negative. It will get harder for companies to pile on more debt if their EBITDA growth does not accelerate;
- Cash to Debt is also declining, although it remains above pre and post crisis levels. But the behemoth cash hoarders – Apple (AAPL), Oracle (ORCL), Microsoft (MSFT), etc – do tend to skew the averages, and without those companies, the Cash to Debt ratio would look quite different;
- Interest coverage is still very healthy at 10.8x, but it too is dropping.
This backdrop reasonably suggests that without a pick-up in EBITDA growth, more and more companies will have to slow down their borrowings, be it for capex or for the shareholders’ beloved dividends and stock buybacks.
Is it the end of times? Hardly. All of the above issues create a corporate bond supply problem. Credit market cycles end when demand dries up. In fact, if these supply issues continue, it is likely that we will see even more aggressive bidding (i.e. lower yields) whenever large offerings hit the market. From an overall credit market health, that is a good problem to have. But if companies must tighten the belt on debt sales, it would make it harder for them to continue returning capital to shareholders, and that could prove disappointing to the equity markets. Incidentally, according to Morgan Stanley, buybacks for Q4 of last year were down 10% Y/Y and flat for 2015 as a whole.
And while on the subject of supply and demand for bonds, it’s now time to put front and center the coming refinancing wall of Commercial Mortgage Back Securities of pre-crisis vintage. This is the worst CMBS paper out there. According to Morningstar, some $155B of CMBS coming due this year and the next will be paid off at 50 to 60 cents on the dollar.
Is this going to trigger financial Armageddon? At risk of disappointing the doomsday preppers once again, I seriously doubt it. There are obscene amounts of money earmarked to refinance the CMBS at those deep discounts, or to pick off underlying assets at healthy cap rates. So what we are likely to see are some headline-making CMBS defaults, laying the foundations for some fat and happy returns to the new buyers. However, the surge in supply of discounted real estate assets may, on the margins, syphon money away from the corporate credit markets and raise the cost of borrowings to companies desiring to sell bonds.
In summary, as has been the case many times since the end of the ’08-’09 crisis, the demand side of the corporate credit markets has once again proven itself to be flush with cash looking for a place to land, especially when volatility creates temporary spikes in yields. But the recent widespread slowdown in revenues and operating cash flow is challenging the ability of companies to accelerate capital returns to shareholders via new borrowings, and the cost of such new borrowings may end up being marginally higher if real estate opportunities capture the attention of buyers of cash-flowing assets.
Who knows, maybe this is exactly the recipe needed to keep this credit cycle from accelerating into a bubble, which in turn increases the chance that it may last for longer than the bears’ worst nightmares.
Thanks for reading and good luck out there!
After publication Morningstar reached out to me with the following clarification: We believe that the 50 to 60 cents on dollar comment may be the result of a misinterpretation of the piece in CRE Direct. We mentioned in the article that the payoff rate for loans could be below 60%. What this means is that we believe that less than 60% of the loans that are maturing in the next year or two will successfully refinance. Even when a loan does not get refinanced successfully, it doesn’t mean that the loan will lose money. In fact, for a number of the loans, the property value will still exceed the outstanding loan balance. It’s just that lenders may target a maximum loan-to-value ratio of 75% to 80% and there just isn’t enough value to get there.
Further reading from Fil Zucchi: “Random Thoughts On Global Credit And Equities Markets“
Twitter: @FZucchi
Author does not have a position in the mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
