Like the equity markets and economic activity, the U.S. fixed-income market also moves in cycles. When we think about the credit cycle, we divide it into three broad stages: the recovery, the expansion, and the downturn. Based on qualitative and quantitative factors, we believe we are in the later innings of the expansion phase. While there are still a number of positives, some metrics we monitor are starting to show signs of fatigue. To be clear, these are cracks as opposed to outright erosion, and it’s quite possible this cycle will persist longer than prior cycles. Also, it’s important to note that none of these factors in and of themselves dictate where we are in the credit cycle, rather it’s their cumulative impact.
Fundamentals Remain Positive
On the positive side, from a fundamental perspective we think the backdrop for credit, in aggregate, is relatively healthy. For example, the maturity calendar is benign with minimal maturities coming due through 2018, debt-to-EBITDA ratios are about average, and interest coverage remains near all-time high levels. On the negative side, we have seen a decline in year-over-year revenue and EBITDA growth, coupled with a slight increase in leverage within the high-yield bond universe and a weakening of the upgrade/downgrade ratio.
Quality is Declining
As for the uses and quality of issuance, we have observed a transition in terms of use of issuance proceeds from refinancing during the recovery stage to mergers and acquisitions, though we have not seen the highly leveraged buyouts we saw prior to the financial crisis. On the quality side of things, we have seen an increase in covenant-lite issuance, while CCC issuance as a percentage of new issues is currently in the mid-single digit range—roughly the same run rate during 2003–2007 (it spiked to the mid-double digits in 2007 and 2008). Deteriorating credit quality is certainly a sign of being in the later stages of a credit cycle, but at this point we’re not seeing anything alarming.
Lending Standards are Tightening
We also look at lending standards, where recent trends in bank lending for corporate loans also demonstrate that tightening is underway. Over the past 25 years, changes in bank lending standards have been a strong predictor of high-yield corporate default rates. In the third quarter of 2015, 7.4% (net) of banks tightened lending standards for commercial and industrial loans, the tightest reading since 2009.
Interest Rates and Monetary Policy
An important input to the credit cycle is the interest-rate cycle, which carries a fair amount of weight when it comes to setting the stage for various phases of the credit cycle. If you look at historical cycles of rate hikes, credit spreads generally take time to widen out, with peak spreads occurring about three years after the initial hike, and roughly two years after the end of the rate-hike cycle. This historical view suggests we still have some time before we see yields peak. That said, we cannot ignore the fact that we are dealing with unprecedented monetary policy and low rates that have played a big role in defining this credit cycle. There is no precedent to refer to in forecasting how the unwinding of easy monetary policy will play out and how credit markets will react.
Conclusion
We will continue to monitor credit fundamentals, valuations, and technicals, as well as the macroeconomic backdrop, to gauge where we are in the credit cycle and allocate our portfolios accordingly.
