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Recent events in the debt markets have observers citing all kinds of metaphors in an effort to criticize, defend or promote their position. When Tricolor — a used car dealer and finance company serving subprime borrowers — imploded and was revealed as a massive fraud, it was easy to consider it a one-off situation rather than disparage the entire ABS market.
After Tricolor’s demise came the spectacular fall of First Brands. It was also a tremendous case of fraud and an easier case to deride the private credit markets and the somewhat arcane niche of trade finance. On their recent Q3 earnings call, Jamie Dimon of JP Morgan mentioned that “I probably shouldn’t say this, but when you see one cockroach, there are probably more. And so, we should — everyone should be forewarned on this one…”
After two credit blowups in quick succession, investors started to wonder if those were the aforementioned cockroaches that would likely be quickly joined by more of their kind. Here, we will try to offer some practical signs to look for as the credit market starts to turn. We also will provide solutions to help manage this risk and take advantage of the opportunities that arise, including why the bear phase of the credit cycle could be a good time for active management.
Understanding Credit Cycles
A typical credit cycle is characterized by muted volatility and tightening credit spreads in the beginning. Debt markets are wide open to any and all issuers, with little discrimination. Pricing, covenants and other underwriting considerations increasingly get tossed aside.
When a cycle starts to turn, the opposite occurs. The calm that pervaded the bull market becomes more volatile. The homogeneity of all bonds trading up in unison with little regard for individual credit analysis turns toward more dispersion. Earnings “misses” that were routinely ignored or shrugged off instead trigger bond price drops of five to 10 points.
New issue deals that were gobbled up by the insatiable demand of public and private credit lenders no longer routinely trade up one or two points. Eventually some deals get pulled from syndication before they get completed.
We are starting to see some of these behaviors in recent weeks. Barclays strategists cited on November 14 that for both the high yield market overall — and the CCC rating cohort specifically — dispersion is at an all-time high. During Q3’s earnings season, there have been many examples of earnings misses triggering large bond price drops, particularly in sectors known as early cyclicals such as commodity chemicals, building products, and specialty finance.
Although we haven’t yet seen deals getting pulled, there have been a few that have traded “in the hole.” In other words, rather than trading up immediately on deal closing, they are trading down.
Another signpost to look for is the performance of the group of data center construction deals that have recently been issued in the investment grade and high yield credit markets. They traded very well initially but have recently started to falter. If these bonds trade lower, it will make financing the next hundred billion or more of deals that much more expensive, and cause ripple effects in the equity markets.
