Did Something Blow Up in Junk?

There isn’t much as far as confirmation, but it increasingly appears as if “something” just hit the triple hooks (CCC) in the junk bond bubble. At least as far as one view of it, Bank of America ML’s CCC implied yield, there was a huge selloff that brought the yield to a new cycle high (low in price) above even the 2011 crisis peak.

Now, this had occurred before on August 13 amidst the growing carnage in the “dollar” run through the PBOC and China. The published rate for that day was just over 16% and a similarly huge jump, but that was quickly revised (no reason given) to actually less than the day before. Further, that pricing revision applied to BofAML’s Master II HY index, as well, which had also been initially published in an explosion that day only to erased quickly after.

This time, the CCC index is by itself in showing “something.” Neither the Master II nor the S&P/LSTA Leveraged Loan 100 are following suit. Whether or not that suggests another pricing problem isn’t clear, but the fact that the CCC index actually surged Monday to 16.61% and was reported again yesterday at 16.60% begins to indicate this was an actual trading outcome. In other words, as junk bonds have been the leading edge to the domestic end of the “dollar” run, this demands close and ongoing scrutiny in light of a potential escalation.  After all, this is just another indication of how advanced the deterioration has become, when the “usual” carnage and selloff is no longer noteworthy, giving way to only the (possibly) spectacular.

Submitted by Tyler Durden on 11/30/2015 

4 Telltale Signs The Credit Cycle Is Turning Now

Earlier today, the FT wrote an article in which it found that "companies have defaulted on $78bn worth of debt so far this year, according to Standard & Poor’s, with 2015 set to finish with the highest number of worldwide defaults since 2009" which together with a chart we have been showing for the past year, namely the staggering disconnect between junk bond yields and the S&P500...

... has made many wonder if the credit cycle - a key leading indicator to economic inflection points and in the case of the last credit bubble, the Great Financial Crisis - has already turned. According to a recent analysis by Ellington Management, the answer is a resounding yes.

Below, we present what Ellington believes are the 4 telltale sings the credit cycle is turning now. The full report is a must read for everyone (link here) but for those who wish to know where the overall debt market is headed, the below excerpt is a must read, especially since as Ellington concludes, once "fickle investors exit the market, high yield bonds and leveraged loan prices should settle at a supply/demand equilibrium well below today's levels."

* * *

Telltale Signs the Credit Cycle is Turning Now

We believe that we are now at the end of the "over-investment" phase of the corporate credit cycle in the US that has been playing out since the depths of the GFC. This view is supported by a number of telltale signs of a reversal in the credit cycle:

The turn of the credit cycle from expansion to contraction tends to play out the same way each time. Initial enthusiasm about a new technology, innovation, or policy change creates an investment boom and easier lending standards. This virtuous cycle repeats itself, with stronger fundamentals, lower volatility, and higher leverage. Financial markets facilitate increased leverage, magnifying booms and busts. Return-chasing investors pile in, fueling more debt issuance. Borrowers who would have otherwise defaulted are able to refinance as leverage increases faster than cash flows deteriorate. Over-investment inevitably leads to loans that go sour, and as the tide of leverage goes out, the full extent of irresponsible lending becomes apparent. The previously virtuous cycle between risk spreads and fundamentals goes into reverse, with lower prices, defaults, and downgrades forcing leveraged investors to sell, leading to even lower prices.

As we have shown, the demand for high yield assets today is fickle. Once these fickle investors exit the market, high yield bonds and leveraged loan prices should settle at a supply/demand equilibrium well below today's levels.

Telltale Sign #1: Worsening Fundamentals

As we noted earlier, corporations are now running out of steam in terms of their ability to generate earnings. As of Q2 2015, the year-over-year change in annual corporate earnings dropped to -$8.21 per share for the S&P 500 and to -$4.79 per share for the Russell 2000. The previous three times this metric fell that far into negative territory on the S&P 500 were Q1 1990, Q1 2001, and Q4 2007, coinciding with the start of each of the last three high yield default cycles. According to a recent article in The Economist, in the most recent quarter less than half of S&P 500 companies recorded increasing prots year-over-year.

The average quality of corporate debt issuance has also deteriorated in the past few years. Recent research documents a strong link between issuer quality in corporate debt markets and excess returns over the following 1-3 years. This empirical finding holds when credit quality is measured both in terms of credit spreads (market implied default probability) as well as credit ratings. Our research suggests the lag may be slightly longer, with high HY issuance fractions in 1996-1998 and 2003-2004 being followed by default waves in 2000-2003 and 2009-2011. Again, we believe that the root cause of lower issuer quality in recent years is lower interest rates. First, as central banks have purchased massive amounts government bonds and MBS, they push investors into risky assets that they would not otherwise buy. Second, a declining interest rate environment is helpful to corporate balance sheets, thus creating the illusion that lower default rates are evidence of improving corporate fundamentals.

Since 2010, the HY fraction of total corporate debt issuance has been at or above levels that preceded the last two waves of corporate credit defaults (see Figure 11 below). What is remarkable about today's high HY fraction of debt issuance is not only its level but also its persistence. Unlike the past corporate credit booms of 1997-1999 and 2003-2005, HY companies have faced a very friendly environment of zero short-term borrowing rates and declining long-term interest rates. This has made the most recent credit cycle more extreme and of longer duration than past cycles. Moreover, because the relationship we document between the HY fraction of issuance and future returns has been during a declining rate environment, the predicted excess return over Treasuries is even lower on a duration-adjusted basis.

Telltale Sign #2: Defaults/Downgrades

Many credit investors have mandates to invest only in bonds with minimum ratings provided by the rating agencies. S&P issued 108 downgrades for US non-financial companies in August and September and 297 downgrades YTD, the most in a two-month period since May-June 2009 and the most in a year since 2009.

Downgrades create a perverse supply problem for high yield. Even if issuance were to shut down, downgrades from investment grade to high yield and from high yield to distressed create net new supply in the lower tier sectors. This is relevant because the investors who play in the high yield and investment grade debt markets are two largely disjointed groups. Since there is a lot more investment grade paper outstanding than high yield, downgrades could potentially present even more of a supply issue for the high yield market than high yield issuance.

Ratings downgrades can have immediate impacts on securitized debt as CLOs and other products have ratings provisions that determine how cash flows are allocated to different investors in a securitization. For example, ratings downgrades can shut off payments to the bottom of the capital structure of many CLOs. The size limit on loans rated CCC and below is typically 7.5%. The average CLO exposure to CCC and below is currently up to 4.3% from 2.3% two years ago, while the fraction of CLO holdings just one notch above CCC has remained around 20-25% since 2009.14 If only a fraction of these near-CCC holdings is downgraded, the 7.5% limit will be exceeded, which will trigger a haircut to be applied to the collateral for the purpose of overcollateralization (OC) tests. Once a CLO fails the OC tests, cash flows are diverted away from equityholders.

Because CLOs now absorb 70% of leveraged loan demand, the pricing of par loans will experience a quantum jump down to a new equilibrium level if 70% of demand is taken away. Not only will a halt in CLO issuance lead to a drop in leveraged loan demand, it will also create short-term supply pressures from liquidations of CLO warehouses for deals that did not get done. A number of CLO warehouses are significantly underwater today. We expect to see selling pressure from these warehouses as we approach year-end, especially given the pricing pressure on leveraged loans that has persisted since August. We saw the same dynamics when the ABSCDO and CLO markets shut down abruptly during the GFC

Telltale Sign #3: Falling Asset Prices

Late last year, the first cracks in the high yield edifice began to show with the decline in oil prices. This led to a decline in high yield bond prices, but losses were contained mostly to the Energy sector. As concerns about China weakness intensified this past summer, Metals & Mining also began to feel the heat. However, as Figure 14 shows, while the returns in the Oil & Gas and Basic Materials sectors (the latter of which includes Metals & Mining) have been disastrous over the past year, the rest of the HY bond market is actually up YTD. Moreover, the relative decline in Oil & Gas and Basic Materials has been a slow bleed on a beta-adjusted basis versus the whole sector. While we have seen market jitters, contagion in HY has yet to really extend beyond industries directly impacted by lower oil prices.

One can tell the same story with distressed versus non-distressed high yield sectors. Figure 15 shows the cumulative performance of the S&P US High Yield Corporate Bond Index versus the S&P US Distressed High Yield Corporate Bond Index. Again, the effects of initial fundamental weakness among the most distressed high yield borrowers have not yet percolated up to stronger credits. This suggests to us that it is not too late to get out now.

It is not just Energy and Basic Materials names that are contributing to poor distressed returns today. As Table 1 shows, in 2015 most distressed industry groups are seeing underperformance versus high yield.

Individual sector weakness may at first seem like an isolated issue. However, the contagion process has already been set in motion as the riskiest segments of high yield now trade at multi-year wides. Investors in these assets include distressed investors, leveraged buyers of junior credit index and bespoke tranches, CLO mezz and equity investors, and buyers of new issue Energy sector debt this past spring. Not only are the most leveraged sectors usually the first to crack, but the most leveraged investors tend to have greatest exposure to these sectors. As these investors de-lever, price pressures induce the next round of deleveraging in a negative feedback loop.

As shown in Figure 16, spreads on more senior new-issue CLO tranches (AAA through A) are below their recent trailing averages, while riskier new-issue tranches (BB through B) have widened substantially since July. The same divergence can be observed in the high yield bond market in Figure 17, where lower rated CCC collateral has widened versus B-rated collateral to levels not seen since the GFC.

Telltale Sign #4: Tightening Lending Standards

The marginal buyers in credit markets are the ones who set underwriting standards. Their losses mean that credit conditions are already tightening, and this resetting of underwriting standards is consistent with the high number of deals pulled in October. More generally, cov-lite deals are much harder to get done now. A number of new deals are being done, but with lower fees and wider spreads on the junior mezz tranches.

As loan issuance has declined, so have the prospects for M&A among the riskiest borrowers. In recent months, banks that extended loans to high yield companies to finance buyouts are now unable to sell those loans to investors, who have become skittish about the worst quality high yield debt. We are seeing the immediate effects of this lack of a bid as banks who hold these loans on balance sheet must sell them by year-end in order to avoid significant capital charges, resulting in forced sales at a loss. The risk-averse behaviors of banks since the GFC suggest to us that banks will be much less inclined to underwrite risky deals going forward after suffering such losses.

Recent trends in bank lending standards for corporate loans also demonstrate that tightening is underway, and this has historically been a strong predictor of high yield corporate default rates. As shown in Figure 18 below, there has been an 89% correlation over the past 25 years between changes in bank lending standards and speculative grade corporate defaults a year forward. This predictive relationship is strongly statistically signicant, even after controlling for lagged default rates. This 89% correlation is much higher than the contemporaneous correlation of 62% between the two measures, suggesting that tightening lending standards drive defaults higher. In the third quarter of 2015, a net 7.4% of banks tightened lending standards for commercial and industrial loans, the tightest reading since 2009. While today's tightening in lending standards looks somewhat similar to that in 2011, that blip was more of a head-fake from the Euro crisis, and was therefore a short-term period of uncertainty originating from outside the corporate credit markets, compared to today's tightening where the major source of lender uncertainty is coming from corporate credit itself.

The predictive power of changes in lending standards suggests that tightening lending standards directly impact future default rates, as companies have difficulty rolling over debt. This demonstrates the mechanism by which contagion spreads from a few isolated sectors to all of high yield. As a few sectors underperform, banks experience write-downs and losses, which leads them to tighten overall lending standards. This leads to broader weakness, perpetuating a feedback loop that triggers a default cycle. An imminent Fed hiking cycle today is yet another reason to expect bank lending standards to continue to tighten.

Deteriorating corporate fundamentals would be less of a concern in the short run if investors chose to ignore the fundamentals, but our distressed loan traders have been seeing the opposite. Investor appetite for risky loans has fallen off a cliff. We give four examples from the distressed sector, followed by some sobering statistics from the CLO market.

First, Millennium Labs' leveraged loan was trading at par in April. The loan fell to $50 in June following  allegations that the company was defrauding the government and would have to pay a fine of unknown magnitude. The loan facility is relatively large, at $1.775B in size. A few weeks ago, a block of $20 million (1% of total issuance) became available. Market chatter was around a price of $35 (30% below the market level at the time), for a total of $7 million in proceeds. Even at this steep discount, the block did not clear as the sourcing desk could not find enough buyers.

Second, recent new issues in October have priced very wide to talk or have been pulled altogether. Four deals were pulled in October alone, including SiteOne, Xerium Technologies, Apple Leisure Group, and ABB Optical Group. Other deals are coming out very wide relative to price talk. Fullbeauty Brands had two term loans price recently, with initial talk at $99 and L+450 for an $820 million first lien, and $98 and L+850 for the second lien. These two loans ended up pricing at $93 and L+475 and $87 and L+900, respectively (the latter at a 13.2% yield!). In each of these cases, the banks syndicating these loan transactions were stung
with losses on the loans. Even for deals that eventually clear, banks have been quick to respond to such losses by tightening terms for new issues.

Third, we see weak investor appetite in combination with financial that appear to be managed to slide in just under the radar of regulatory scrutiny. Builders First Source came to market with a deal in April 2015 that was exactly 6.0x Debt/EBITDA, using a pro-forma EBITDA methodology that contained numerous add-backs, which added around $50 million to arrive at a final EBITDA number of $376 million. Excluding these add-backs, leverage would have been at 6.9x, above the 6.0x maximum level that the Federal Reserve and the OCC deemed to be prudent underwriting standards.

Fourth, on September 15th, Moody's downgraded Sprint's senior unsecured debt from B2 to Caa1. Fears of downgrades by the other rating agencies to CCC, which would impact portfolio managers' CCC concentration limits, drove pricing on Sprint's $2.5 billion of bonds maturing in 2028 from $88.40 the day before the downgrade to $80.80 two days later. Being one of the largest names in the high yield universe with $30 billion in total debt outstanding, this price shock was felt across debt markets. While prices eventually recovered, such large price swings on a single ratings downgrade show the extent to which investors have been willing to sell debt at the first signs of trouble.

Adding to this anecdotal evidence, there is an overall trend this year of declining issuance in lower-rated US HY corporate credit. As shown in Figure 19 below, total US CCC issuance this year stands at $30B on an annualized basis as of the end of October, down 48% from its peak of $58B in 2013. In contrast, overall US HY corporate debt issuance has fallen only 16% over the same period.

The CLO market has also exhibited recent signs of weakness on both the supply and demand side. In terms of supply, leveraged loan issuance is down more than a third year over year and since June, and the rate of US CLO issuance has fallen to half the 2014 rate (Figure 20). Pricing on new-issue CLO equity has weakened substantially given the weakness in high yield Energy, Metals & Mining, and Power/Utilities. Weakness in one sector is enough to make equity and BB tranches risky enough to lack a bid, which should impair CLO issuance.

To JPM, This Is The Alarming Chart Suggesting The Next Recession "Is Just Around The Corner"

By now it is clear to even the most tenured economists that the half of the US economy, the one that deals with manufacturing and industrial production, is sliding into, if not already, in recession with today's contractionaryChicago PMI and subzero Dallas Fed data confirming this deterioration.

But while the NBER is notoriously behind the curve when it comes to determining the onset of recessions, the market may have already spoken, and nowhere louder than in the collapse of corporate cash flow generation. This collapse in EBITDA is also what we cautioned three weeks ago is the biggest risk facing the economy.

This drop in cash flow is also one of the key catalysts listed by JPM in its report (noted earlier) which said it is time to lower allocation to US equity exposures as "the long period of indiscriminately buying any dip might be coming to an end."

Specifically, JPM looks at the corporate financing gap, the difference between organic cash flow and the outflow on dividends and buybacks, and is very concerned with what it sees.

The current deterioration in the credit market is particularly worrying at a time when corporates are becoming more and more dependent on external sources of liquidity. The US corporate financing gap – the difference between cash flow generation and spending on capex and dividends – has turned strongly negative. In the past, when the financing gap went strongly negative, the next downturn was just around the corner.

And here is the chart which JPM believes suggests the next downturn may be "just around the corner."

Will it be different this time? Here JPM is pessimistic again, for the simple reason that any attempts to extrapolate profit margins, the lifeblood of corporate cash flows, suggests that much more pain is ahead:

"If we were to perform a simple modelling of NIPA margins, using as inputs the unemployment rate, wages and nominal GDP growth, we get as a result a clear deceleration in profit margins next year."

One wonders, and can only hope, that these observations are part of the Fed's deliberations as Yellen and company sit down in two weeks to discuss whether the US economy is finally "strong enough" to weather the first tightening cycle in nearly a decade.

 

CORPORATE & SOVEREIGN BOND DEFAULTS

TO SEND SHOCK WAVES INTO CURRENCY MARKETS

 

Gordon Long, FRA Co-Founder had a conversation with Bill Laggner. Principal and Co-Founder of Bearing Asset management in Dallas, TX. Mr. Laggner and his partner manage the Bearing fund using an Austrian economics lens in terms of identifying boom-bust cycles, value in the market place, bubbles, and distortions created by both fiscal and monetary authorities to manage wealth in today’s environment that’s unprecedented in terms of intervention.   

“We started back in 2002, creating the Bearing credit index when we say that authorities would not let the recession play out”

On describing the Austrian school of economics, Mr. Laggner says that Austrian economists would categorize their theory as human action and individual decision making and their responsibilities of those decisions being what really creates normal economic activity. He points out how unfortunate it is that today we have fiscal and monetary intervention which distort human actions.

“We create these boom-bust cycles that are magnified by the very interventions that we’re witnessing today”

SAVINGS & PROPER ALLOCATION OF THOSE SAVINGS

Mr. Laggner thinks that one of the key aspects of the Austrian economic theory that investors should pay attention to is that one has to have savings and a proper allocation of those savings. He also says that people have to quantify both risks and return as well.

“In that environment as well, you would want interest rates to be set by the market place and not a group of bureaucrats who are essentially socialising credit”

On whether we have an inflation or deflation right now: There is a lot of discussion about inflation in the Austrian theory in terms of the phenomena comes about in terms of pricing, in  light of that we have deflation in commodity prices which was a function of the excess supply created by false signals coming out of China. According to Mr. Lagger we are facing a deflationary state as of right now.

Mr. Laggner has looked into commodities in China and could tell that it was hard lending as debt was not serviced there and the fact that Glencore was essentially extending credit into the Chinese market place while the signals were false, the copper breaking down meant the company got into huge amounts of debt. In as recent as September their shares nose-dived 30pc. So China and Glencore are the canaries in the coalmine when it comes to credit cycles in the commodity market.

CREDIT CYCLE HAS TURNED

Mr. Long stated that the credit cycle is now changing, taking its signals from the business cycle. This was agreed upon by Mr. Laggner who in his own words said:

“We’re at the end of the credit cycle, the whole mal-investment in shale oil…tens of billions of dollars in lost wealth”

For the future, Mr. Laggner anticipates a massive series of defaults, resulting from huge deflationary pressures and a tightening by the market place, which is basically an unintended result of constant intervention. We are looking at corporate bond defaults, sovereign defaults which will send shockwaves into the currency system.

“we’re probably looking at some kind of new currency system, which looks likely to be gold”

At Bearing Asset Management: They run an aggressive, long-short portfolio, they looked at eco-bubble that were shortable they thought the stock prices would be wiped out. So ultimately they shorting something that eventually goes to zero. However they went long on Gold.

Mr. Laggner points out even in the turmoil we’re in he remains optimistic. He thinks that technology will be the savior as the wheels are coming out from the bus, looking at how the internet connects people all over the whole who do business daily.

“we’re coming to a realization that we can look to each other and share expertise, knowledge, goods and shy away from things like speculating in commodities, speculating in real  estate, speculating in the stock market and get back to pricing money correctly…”

“The beauty of America is that the entrepreneurial DNA in this country is unlike any other part of the world”

Mr. Long mentioned that if we could take away centralized control and planning from the planners and controllers in a logical fashion, adjustment will happen. He said that “a crisis is nothing but more than change trying to happen.”

If people want to get more information and insight from Mr. Bill Laggner, they could go to Bearingasset.com/blog. They write a lot about relevant topics relating our wealth and the financial markets.

Abstract by Agang Moeng. Can be reached at [email protected]