The Looming Shift on the Credit Cycle Horizon


May 18, 2016

“History does not repeat itself, but it rhymes.” 

– Mark Twain

As value-based investors operating within (mostly) mean-reverting fixed income markets, we believe it is important to have a full cycle approach to credit investing. By appropriately calibrating portfolios to evolving risks during the credit cycle, long-term value investors seek to exploit their advantage over tactical competitors when the risk/reward asymmetry shifts in their favor. Each cycle is unique, but there are typically several themes that are similar each period which offer clues to both prospective opportunity and peril. Our analysis of past deleveragings suggests to us that we are in the final stages of the current credit cycle, notwithstanding the recent rally in risky assets.

While attempting to pinpoint the exact peak or trough in any cycle is a fool’s errand, building a mosaic of data points can help determine if an inflection point is looming on the horizon, which may not be fully discounted in the markets. There are four distinct and sequential periods in each credit cycle that are similar over time: 1) Debt Reduction; 2) Profit Growth; 3) Debt Growth; and 4) Profit Decline (Chart 1). Various data points, such as the use of proceeds for new issues, lending standards, profit growth and valuations provide clues to where we are in the credit cycle. Although the sequencing of each phase is fairly uniform, the duration of each phase differs greatly. Typically, each credit cycle has a long period of lower volatility, followed by short turning points with increased market volatility that culminates in a systemic deleveraging.

Chart 1: Phases of the Credit Cycle

Source: TCW, MWHIX targeted rating listed for each phase.

Each credit cycle ends with a deleveraging phase referred to as “Debt Reduction” as highlighted in Chart 1. During this period, banks and other fixed income investors significantly reduce lending as an increase in rating downgrades and restructurings lead to investment losses. The capital markets effectively shut down and are closed to marginal issuers, which typically have some combination of high leverage and eroding fundamentals. The market also begins to discriminate between investments based on asset value, as opposed to yield or coupon. Eventually, prices hit bottom when distressed investors are motivated to underwrite bonds at substantial discounts to par, where the downside is limited relative to the potential upside once the economy improves. Thus credit markets typically rebound first, given the potential “equity-like” returns of discounted bonds with a return profile that is skewed to the upside as corporations focus on balance sheet repair (Chart 2).

Chart 2: Credit Leads Stocks

Source: Bank of America Merrill Lynch, Bloomberg

As prices recover in the secondary market and banks skeptically lend to stronger credits, the recovery process begins anew, spurring a new virtuous cycle of positive feedback. Animal spirits are rekindled as prices recover and large inflows begin to chase historically strong returns. Profits and the economy improve with a lag as credit creation fuels growth. During this second phase of “Profit Growth,” earnings (EBITDA) growth exceed debt growth as corporations exploit their operating leverage and invest in projects with high returns on capital. This dynamic can be seen in Chart 3 as the second phase peaked in Q1’05 and Q3’10 during the most recent credit cycles. During the initial stages of this healing process, underwriting standards are typically fairly restrictive and favor creditors over debtors, with strong covenants and minimal ability to issue more debt.

Chart 3: Peaks/Troughs During the Credit Cycle

Source: TCW, Bank of America Merrill Lynch, as of December 2015

As spread premiums remediate and the gains from operating leverage subside, corporations must rely upon financial leverage to keep profit growth strong during the third phase of “Debt Growth.” Strong demand from investors leads to narrow spread premiums and loose underwriting standards which favor debtors over creditors. Corporations become focused on equity friendly activity, such as share buybacks and mergers, often funded with low coupon debt which allows increasing debt loads. This dynamic can be seen in Chart 3 as the third phase which peaked in Q3’07 and Q2’13 during the most recent credit cycles. The market ceases to focus on asset value and instead shifts towards indiscriminate buyers of credit risk based on yield and forward projections of profitability and growth. As credit creation expands with a growing proportion of marginal transactions, inevitably some malinvestment is created, sowing the seeds for the next default cycle. As shown in Charts 4 and 5, each debt expansion is marked by an increasing overall debt load with CCC-issuance highly correlated with the peak and trough of debt growth. Each credit cycle typically shows a 50-70% growth in outstanding bonds with cumulative CCC-issuance, as a percentage of new issues, rising to 17-20% of the market.

Chart 4: HY Debt Growth

Source: Deutsche Bank, as of February 2016

Chart 5: CCC-Rated Issuance

Source: Deutsche Bank, as of February 2016.
Cumulative CCC-rated growth in shaded area, % of entire market on left axis.

During the fourth and final “Profit Decline” phase, the marginal borrower has difficultly accessing markets, banks get nervous, large price gaps occur and terms begin to favor creditors again. The virtuous cycle of positive feedback abruptly shifts towards a vicious cycle of negative reinforcement that permeates the market. Lower profits beget lower security prices, which begets a contraction in bank lending and capital market activity and then ultimately leads to an increase in corporate defaults. This dynamic can be seen in Chart 3 as the fourth phase which troughed in Q3’02 and Q3’09. Today we are in the beginning of this phase. During this inflection point in the markets, it is difficult to reduce risk within a portfolio without a significant decline in price. Attractive yields are required to entice unlevered buyers to underwrite risk over the long term and assume more price volatility. As typical liquidity providers such as hedge funds and brokers exit the market, distressed and value investors often set the price of risk well below the current trading levels.

Evidence strongly suggests we are currently in the Profit Decline phase. Debt growth has exceeded profit growth since late 2012, leading to significant outperformance for equities relative to the credit markets (Chart 6). From Dec’12 to Mar’16, the annualized return for the S&P 500 and U.S. HY was 27% and 3%, respectively. During the early phase of the credit cycle, both equity and high yield bond returns are equally robust. However, late in the cycle equities outperform given corporate actions that benefit shareholders at the expense of creditors. This dynamic also existed in 2006-07, but eventually reversed course once earnings began to decline (Chart 7). The current pace of earnings growth has slowed, and is now negative over the last year. When earnings decline with growing or static debt loads, markets typically send strong signals to de-lever balance sheets and potentially stop equity friendly activity (i.e. share buybacks) to reduce default risk.

Chart 6: Equities Outperform Late in the Cycle 
Cumulative Returns (100 = Base)

Source: TCW, Bank of America Merrill Lynch, Bloomberg

Chart 7: Until Profits Decline 
Cumulative Returns (100 = Base)

Source: TCW, Bank of America Merrill Lynch, Bloomberg

Chart 8: Profit Decline –> Labor Reduction

Source: TCW, Bank of America Merrill Lynch, Bloomberg
As of December 2015 (profits) and March 2016 (jobs)

As profits decline, companies will look to cut labor costs to adjust their cost structure to the new operating environment. In the past, periods of negative profit growth were a leading indicator for “Main Street” economic data points, such as employment (Chart 8). The current decline in profits is likely to lead to declining payroll data with a lag as corporations look to adjust their cost structure. When profits decline and banks experience mark-to-market losses, creditors get nervous and the availability of capital evaporates. This contraction in credit impacts marginal borrowers almost immediately as they lose access to financing and are forced to manage their declining liquidity for the benefit of creditors. If companies are unable to raise cash via asset sales or generate cash flow to meet operational expenses and debt service requirements, a restructuring might be necessary.

In addition, if companies are deemed to have inadequate asset coverage and are insolvent, senior creditors may force companies to restructure to avoid value leakage to junior creditors such as subordinated bondholders and shareholders. Given these dynamics, defaults typically increase 12-24 months following a sharp tightening of lending standards, as evidenced by the Fed’s Senior Loan Officer Survey. The most recent data suggest that banks have started to tighten standards, which implies that the default rate will increase over the next several quarters (Chart 9).

Chart 9: Credit Tightening Leads Defaults

Source: TCW, Moody’s, Bloomberg, as of April 2016

Each credit cycle has a few “problem” sectors where credit growth was misallocated to marginal businesses. As the credit cycle turns, credit spreads in the industries with the most malinvestment suffer disproportionately. Initially the volatility is contained to these areas, but inevitably it spreads as investors/banks sell “safer” assets to meet liquidity/riskreduction needs. This cycle, the dislocation manifested itself within the energy, metals and mining (“EMM”) industries.

A common occurrence during these periods is to initially quote the market excluding these sectors, for example “Ex-Energy/ Materials” today or “Ex-Financials” in late 2007. Over the last 25 years, the index, excluding the two widest industry spread premiums, has traded 120bp to 315bp tighter than the rest of the market (Chart 10). Although the volatility is the most acute within the sectors with the highest degree of malinvestment, deleveraging episodes destructively spread throughout the entire market with various degrees of severity.

Chart 10: The Amount HY Spreads Are Tighter Excluding the Two Widest Sectors

Source: Morgan Stanley, as of April 2016

There are growing signs that credit stress is not contained today. In fact, today earnings growth is declining on an annual basis in other sectors, not just EMM, including consumer products, gaming, retail and utilities. While fundamentals have eroded, markets have also reflected this reality. The percentage of the market trading distressed (+1,000bp) is approximately 11% for HY Ex-EMM, compared to 15% for the entire HY market. Thus, the impact of EMM on the distribution of spreads is relatively modest. Approximately one quarter of HY, Ex-EMM index trades wide of +700bp, well above the average of the HY index, suggesting that it is not contained (Chart 11). As the contagion spreads and prices decline, creditors will attempt to restructure balance sheets to gain control of the cash flows to minimize value erosion, leading to an increase in default activity.

Chart 11: Distribution of HY Spreads

Source: Barclays, as of May 2016

According to Moody’s, the annual default rate has increased from 1.6% as of Sep’14 to 4.4% by Apr’16. Moody’s base case estimate for the trailing twelve month default rate on December 31, 2016 is 6.2%, largely due to EMM defaults. If accurate, this would be the highest default rate since 2010, and similar to late 1999 and late 2008. During the last two default cycles (2000-02 and 2008-09), defaults rose from approximately 2% to 6% during the first two years, but ultimately peaked at over 10% as the contagion spread throughout the credit markets (Chart 12).

Chart 12: Historical & Projected Default Rates

Source: Moody’s, as of April 2016

A good leading indicator of future defaults is the percentage of bonds trading at distressed levels or below $60 in price and/or wide of +1,000bp. As the default probability rises, high yield bonds begin to trade near recovery value (i.e. percentage of par value recovered in a restructuring). The percentage of bonds trading below $60 (60% recovery value) briefly reached 12% during Q1’16, the highest level since 2009 and similar to 2000 and 2008 levels (Chart 13). This provides further evidence that the high yield default rate is likely to increase during the second half of 2016, and eventually peak near 10%, as banks and investors alike become more discriminating with capital allocations. The large price declines and high percentage of bonds trading based on recovery values suggest a new default cycle is imminent.

Chart 13: HY Bonds Trading Below $60

Source: JP Morgan, as of April 2016

The recent volatility in credit markets was likely a dress rehearsal for increased volatility in the credit markets over the next several quarters as the ability of central banks to dampen volatility wanes. The credit cycle has shifted from a virtuous cycle of positive feedback towards a vicious cycle of negative reinforcement. As this inflection point becomes more visible, lower prices will be required for unlevered investors to underwrite risk, especially given today’s lack of trading liquidity. Thus, TCW has defensively positioned our client’s portfolios ahead of this shift, patiently waiting for better valuations in mean-reverting or “bendable” assets while avoiding “breakable” assets that will restructure. Within high yield strategies, TCW is overweight BB-rated credits while underweight CCC-rated credits, where cumulative default rates exceeded 50% in past deleveraging episodes.

For other core plus accounts with less risk appetite, TCW is focusing on investment grade bonds and top of the capital structure ABS/MBS securities while waiting to invest in high yield corporates or securitized bonds with less credit enhancement. Over the course of a full credit cycle, market prices typically overshoot to both the upside and downside given the underlying fundamentals. The recent bear market rally has led to higher prices, despite the lack of any meaningful fundamental improvement. For long-term investors, such as TCW, valuations are the most important driver of prospective returns. The looming volatility from the shifting credit cycle should provide better entry points to buy riskier assets, and thus, superior expected returns for our clients.

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW