Junk Debt Sends Early Warning Signals (#GotBitcoin?)
Distressed ratio in high-yield bonds rose to three-year high in August. Junk Debt Sends Early Warning Signals (#GotBitcoin?)
Warning signals are starting to flash in the market for junk debt, an indicator that investors are worried that companies with high debt loads could be at risk even if the U.S. economy avoids recession.
The current change in sentiment is modest compared with the one that hit high-yield bonds in December. But it continued through a recent surge in demand for Treasurys and investment-grade corporate debt. The combined trends expose cracks in the recent rally that has powered the Dow Jones Industrial Average to within 0.6% of its July record.
Forecasting downturns in corporate debt has been tricky since the financial crisis. Central bankers have been reluctant to raise interest rates for fear of triggering a slowdown. The resulting decade of cheap money allowed riskier companies to borrow more to stay afloat, keeping default rates low for an unusually long time.
That could continue as long as the Federal Reserve and European Central Bank maintain their cautious approach. The Fed is expected to cut rates a quarter percentage-point at its September meeting this week.
Nevertheless, more bond specialists are trimming back on high-yielding debt to protect against losses should the credit cycle again turn.
Here Are Some Bellwethers Of The Growing Junk-Debt Anxiety
By one key measure, the risk in the high-yield bond market is at its highest level since 2016, when a sharp slide in oil and natural-gas prices triggered a string of energy-sector defaults. The U.S. distress ratio, which is the proportion of junk bonds that yield more than 10 percentage points above Treasurys, jumped to 9.4% in August this year from around 6% in July, according to data from S&P Global Ratings.
Bond yields rise when investors demand higher compensation for lending out their money. A surging distress ratio reflects a sharp change in risk appetite.
“We think fundamentals are weakening even if the U.S. avoids a recession,” said Matt Eagan, co-manager of the $10.8 billion Loomis Sayles Bond Fund, which invests in a mix of corporate debt and equity. The fund has cut its exposure to junk debt to 22% from about 26% at the start of the year; it has raised its allocation to cash and Treasurys slightly, to 26%.
Declining earnings and rising debt loads are crucial to measuring credit quality. But access to fresh capital is equally important to junk-rated companies—they usually lack the cash to pay off debt as it comes due and rely on refinancing.
That has become more costly in recent weeks as investors have pivoted away from borrowers with below-investment-grade ratings toward companies that are more stable but pay lower yields. Investors pulled about $6 billion from mutual funds and exchange-traded funds that buy high-yield bonds and leveraged loans and put almost $20 billion into investment-grade corporate bond funds in the six weeks ended Sept. 11, according to data from Lipper.
The liquidity squeeze forced junk-rated companies to sweeten terms of new deals to attract sufficient interest. About one-quarter of borrowers in the leveraged-loan market cut pricing during their marketing processes in August, up from 20% in July and 17% in June, according to data from LCD, a unit of S&P Global Market Intelligence.
Default rates may remain low if easy monetary policy persists. But junk bonds and loans are also risky because they can suddenly drop from one credit-rating category to another due to declining earnings, rising debt loads or both, Mr. Eagan said.
“A lot of people think mostly about defaults and don’t realize the losses that can come from downgrades,” he said.
A steep decline in the price of loans with triple-C ratings—the lowest rung in the credit-ratings ladder—is a sign investment firms are preparing for more downgrades to the bottom category.
Most managers of mutual funds and collateralized loan obligations, or CLOs, have restrictions on how much triple-C debt they can hold. They typically jettison loans with the low rating when they expect more single-B loans to get cut to triple-C.
The selling triggered losses in triple-C-rated loans in August for the first time this year, counting price changes and interest payments. Meanwhile, safer loans with double-B ratings posted gains.
“CLO managers are creating space because they’re sensitive to the risk of more loans getting downgraded to CCC,” said Joseph Rotondo, a senior portfolio manager at Invesco Ltd., which manages $32.5 billion of leveraged-loan investments.
Selloff In Complex Investments Flashes Warning For Junk Bonds
Losses in October virtually wiped out returns in some CLO bonds.
Stocks rose to records in October. One corner of the debt market had a rougher time.
Some securities in the $680 billion market for collateralized loan obligations, or CLOs, lost about 5% in October, reflecting worries about rising risk in the complex investment vehicles. The declines were a rare stumble for the CLO market, which has grown by about $350 billion in the past three years, according to data from S&P Global Market Intelligence, fueled by demand from government pensions, hedge funds and other yield-hungry investors.
“We think there’s more volatility coming,” said Maggie Wang, head of U.S. CLO strategy at Citigroup. “We recommend investors reduce risk and stay with cleaner portfolios and better managers.”
The trouble hitting CLOs could be a sign that the trillion-dollar market for high-yield bonds also is headed for a rough patch.
CLO managers buy bundles of below-investment-grade, or “leveraged,” corporate loans using money raised by selling bonds and stock to outside investors. Cash flow from the bundled loans pays interest and principal on the CLO bond with any surplus going to the CLO shareholders.
In recent years, CLOs have bought more than 60% of newly issued leveraged loans, according to S&P Market Intelligence. That makes them a critical piece of the machinery that provides funding to businesses with lower credit ratings. Soft demand for CLO debt can flow through to the corporate-loan market, raising borrowing costs for companies.
CLOs resemble the mortgage-backed bonds that imploded in 2008, but very few defaulted in the credit crisis, a key driver of their recent popularity. Prices for their shares and bonds, however, plummeted at the time, and holders who sold out took heavy losses.
Now some CLO bond prices are falling again. That is because the riskier loans the CLOs own are dropping in value as the companies that borrowed them start running out of cash. CLO bonds rated double-B, which are among the riskiest CLO securities, returned about 10% this year through June. But recent declines, especially last month, erased most of the gains, giving holders a roughly 1% return this year through October.
That contrasts sharply with high-yield bonds: Many of the same companies to which CLOs lend issue junk bonds, which returned about 12% this year through October, according to data from S&P Global Market Intelligence.
“If you think that double-B CLOs are giving a warning sign, that says something about high yield,” said David Preston, head of CLO research at Wells Fargo & Co. “It’s hard to see how both markets can be right.”
Double-B CLO bond yields, which fall as prices rise, are about 5 percentage points higher than the yield of comparably rated junk bonds, according to data from Palmer Square Capital Management, which manages and invests in CLOs. The yield differential hasn’t been this wide since early 2016, when dropping oil prices sparked a selloff in both leveraged loans and high-yield bonds.
To be sure, the disconnect between CLO bonds and high-yield could reflect an overreaction in the CLO market. Many riskier asset classes including emerging-markets stocks and commodities have gained in recent weeks, fueled by increased optimism about global economic growth.
Angie Long, Palmer Square’s chief investment officer, is buying double-B CLO bonds at prices around 90 cents on the dollar, betting they will snap back in the long run. “We’ve been increasing our double-B allocation in the last month,” she said.
Lenders Brace for Private-Equity Loan Defaults
Financial institutions raised default probability estimates for loans to private-equity-owned companies.
The default risk of companies owned by private-equity firms is 2.5 times that of their public counterparts, according to data collected from banks, insurers and asset managers by analytics firm Credit Benchmark.
Private-equity firms use leveraged loans, rated below investment grade, for the financing of buyouts of target companies. Financial institutions raised their estimates of the average probability of default—or nonpayment—for such loans to about 6% in September from 5.44% a year earlier, according to the data.
Lenders surveyed by Credit Benchmark assigned a 2.36% default probability to leveraged loans of public companies in September, compared with 2.28% a year earlier.
Default expectations are typically higher for privately owned companies because “there are fewer constraints on the debt levels of private firms,” said Thomas Aubrey, a risk and compliance adviser at Credit Benchmark. But the jump in the default risk of private-company loans compared with public ones shows “there’s a potential for things to deteriorate much faster, particularly in a down market,” he said.
The finding comes as worries mount about a turn in the credit cycle and a rise in corporate distress. Easy money from central banks has kept default rates relatively low since the 2008 financial crisis, but rising corporate debt is flashing a warning sign to investors, Morgan Stanley bond analysts said in a report published Nov. 19.
“Leverage remains high, and a majority of other cycle indicators we track are in the ‘red zone,’” the analysts wrote.
About 57% of companies purchased in leveraged buyouts now carry debt loads more than six times their earnings before interest, taxes, depreciation and amortization, or Ebitda, according to Morgan Stanley’s report. That exceeds the 51% ratio in 2007 on the eve of the financial crisis, according to the report.
Companies that default on their debt can end up in bankruptcy. Toys “R” Us, a high-profile example, filed for chapter 11 bankruptcy protection in 2017 after it failed to repay loans from its leveraged buyout by private-equity firms. Months later, it was liquidated.
S&P Global Ratings expects the U.S. default rate—which is distinct from default probability—of companies rated below investment grade to rise to 3.9% by September 2020 from 2.8% in September of this year. But in a pessimistic scenario of heightened trade disputes and political instability, the rate could hit 5.2% next year, the ratings firm said.
A jump in leveraged-loan defaults could have more impact on global finance than in years past because there are far more of the loans in existence and they are broadly held by mutual funds, institutional investors and collateralized loan obligations, or CLOs.
Price declines in loans with low credit ratings triggered a 5% loss last month in the value of some CLO securities. The value of loans outstanding has roughly doubled since 2008 to about $1.2 trillion, according to data from S&P Global Market Intelligence.
The rise in lender default expectations indicates a 10% deterioration in credit risk in leveraged loans, according to Credit Benchmark. The analytics firm pooled lender estimates of 221 companies with leveraged loans outstanding, including 134 public borrowers and 63 private-equity-owned borrowers.
Low Liquidity Fueled Hidden Flash Crash in Junk Bonds
While most markets were calm last fall, the market for below-investment-grade corporate debt saw wild price swings.
When Party City Holdco Inc. PRTY 5.18% reported a large decline in quarterly earnings in November, holders of the retailer’s junk-rated debt scrambled to sell. Buyers were hard to find, and prices cratered by as much as 50% before recovering some of the loss.
Investors who didn’t sell the company’s bonds and loans took paper losses of about half a billion dollars in five trading days, according to a Wall Street Journal analysis of data from MarketAxess and IHS Markit. It was the largest price move since Party City issued the debt.
Such violent price swings were commonplace last fall in the riskiest segment of the roughly $2.4 trillion market for corporate bonds and loans rated below investment-grade, analysis of trade data by the Journal shows, striking a sharp contrast to the relative calm in most markets at the time.
Prices snapped back sharply in December, but the volatility confirmed traders’ fears that poor liquidity—how easily sellers and buyers can transact—in high-yield debt is making the market particularly vulnerable to such flash crashes.
“Given the spikes in volatility, you have to be more tactical in your trading,” said Steven Rocco, a partner and high-yield fund manager at Lord Abbett. “We definitely are weighing liquidity more now.”
Dips in the riskiest segment of the junk bond markets were more extreme this autumn than in December 2018, when volatility ravaged global markets, according to the Journal’s analysis of trade data from MarketAxess.
The worst-performing high-yield bonds declined by an average of 8.26 cents on the dollar in the four weeks ended Nov. 22, compared with a peak loss of about 7 cents in late 2018. The S&P 500 lost 14% in the fourth quarter of 2018 but gained 8.3% in the last quarter of 2019.
The trend also hit prices of leveraged loans rated below investment grade. The portion of loans trading below 80 cents on the dollar held by collateralized loan obligations, or CLOs, roughly doubled to about 4% in mid-December from approximately 2% in June, according to data from Wells Fargo Securities.
The more frequent such air pockets become, the less willing high-yield investors are to buy when prices are falling. Distressed-debt hedge funds that historically snapped up risky bonds during such market dislocations are also more cautious after getting burned in recent years.
“In December 2018 we saw a complete lack of liquidity, and that was a wake-up call for everyone,” Mr. Rocco said.
To be sure, investors remain eager to buy the debt of safer high-yield companies with double-B credit ratings, and the selling was concentrated in the riskiest segment rated triple-C and below. The average yield investors demanded to hold triple-C bonds at the end of December was 3.07 times higher than that of double-B bonds, above the peak during the credit crisis of 2.82 times, according to data from CreditSights and ICE BofAML Indices.
Risk PremiumA measure of risk in triple-C bonds now exceeds credit-crisis levels.
“There has been indiscriminate selling of lower-rated loans,” said James Fitzpatrick, head of loans at investment firm CQS, which manages about $19 billion for clients and has been buying as prices fall. “A lot of the selling is coming from ratings-sensitive funds who are trying to manage downgrade risk.”
Most mutual funds and collateralized loan obligations, or CLOs, have limits on how much they can invest in debt rated triple-C or lower—the bottom of the credit ratings ladder. As the risk of downgrades rises, such funds grow more prone to jettison lower-rated companies over earnings misses they would have overlooked in years past.
Burger chain Steak ‘n Shake Operations Inc.’s loan rated triple-C fell about 18% to 60 cents on the dollar in November before rebounding to around 70 cents, according to analytics service Advantage Data Inc. Chesapeake Energy Corp. ’s bond due 2027, which are rated triple-C, fell about 30% to 47 cents on the dollar in November, after the company reported disappointing third-quarter earnings, according to data from MarketAxess. It then recovered almost all of the loss in December.
Some investors see the gaps as buying opportunities—the result of technical factors that leave gains available for those who have more flexibility to hold debt at the bottom of the ratings spectrum.
“They’re throwing the baby out with the bath water,” said Vincent Ingato, a portfolio manager at ZAIS Group LLC who bought some Party City and Steak ‘n Shake loans when they dropped in November.
Lord Abbett also has been buying on dips, but the firm is avoiding new bond sales with low ratings that are often marketed at 100 cents on the dollar, Mr. Rocco said.
“After what we saw last year, we will be cautious about new triple-C issues,” he said.