We're Seeing Something Strange in the Credit Markets Right Now

Credit markets usually show a risk-on/risk-off pattern. That is, when it is a risk-on market, all credit tends to perform well, with riskier credits performing the best. When it is a risk-off market, the opposite is true. Right now we are getting an unusual divergence. Broadly, markets have traded in a mostly risk-on mode this year, with the S&P 500 up 23% and the iShares iBoxx High Yield Corporate Bond exchange-traded fund up nearly 12% through Tuesday. But not all credits have participated, and very recently some of the most marginal segments have been particularly weak. Here is what this means for you. Weaker Credits Disappoint High-yield bonds started this year similarly to stocks. After a very weak 2018 fourth quarter, we saw a rapid rebound in early 2019, as the Federal Reserve backed off rate hikes. Through April, the three major credit quality categories within high-yield performed about the same, jumping around 9%. From the end of April through Tuesday, BB- and B-rated bonds have done fine. But CCC-rated bonds are a different story, dropping 3.7%. (Source: Bloomberg Barclays Indices) This is the weakest segment of the market that isn't actually in default. It is very unusual to get fairly strong performance from BB-rated bonds but negative performance for CCC-rated ones. In fact, if 2019 were to end today, it would be the first year since 2001 that overall high-yield spreads were tighter, but CCC underperformed. The Cracks Extend Into Lending Markets Bank loans tell a similar story, with CCC-rated leveraged loans underperforming. We even see it in private credit. According to a Wells Fargo report BB-rated middle-market loans have reversed all of the fourth quarter 2018 widening and then some, whereas B-rated loans are still wider than third quarter 2018. The pressure isn't technical, it is fundamental. We can see this most clearly in the collateralized loan (CLO) market. A CLO is a fairly simple asset-backed security in which the underlying assets are bank loans. These usually have five or so tranches of debt sold to the public, with one in each ratings category from AAA to BB. So far this year, the higher quality segments of this market have performed well. The AA-rated segment of this market trades with a spread vs. LIBOR about 15 basis points tighter than at year-end, suggesting that holders have enjoyed mild price appreciation on top of the yield. (Remember, LIBOR -- or the London Interbank Offered Rate -- is the global benchmark rate for short-term loans.) But the BB segment is actually wider this year, going from about 720 bps on Jan. 1 to 775 bps on Tuesday. That represents about a 4% decline in price. While trading in CLOs can be technical (it is a relatively thin market) the severe underperformance of lower quality tranches suggests investors expect defaults to go up in 2020. CCC Bonds Are Hard to Sell Now Perhaps most damning is that it has been hard to bring CCC-rated bonds to market. According to the S&P, there has only been six new issues in the USD high-yield market-rated CCC so far this quarter, but even that misstates the stress. Several lower quality deals have been pulled or had to come with substantially more coupons than originally planned. I can't remember a time when there was such a bifurcation between low quality and medium quality deals. Maybe 2003 was a little like this, but certainly having BB deals come white hot and CCC ice cold is very unusual. Does Something Have to Give? If the economy is to slow, CCC-rated companies will struggle. According to Moody's, 35% of CCC-rated bonds will default over a five-year period based on historic averages. The last three recessions have seen cumulative CCC default rates over 50%. So poor performance from CCC is understandable if the market is projecting a slowdown. BB-rated bonds perform fundamentally much better. Those default rates were about 4% over the last three recessions. So even if we knew a recession was coming, BB-rated bonds don't need to decline much in price to make them fair value. I'd argue that BBs trade more on flows and liquidity conditions and less on worries about literal defaults. So what is the market actually telling us with this divergence within the credit market? First, a slowdown is likely. Second, the market is confident that the reach-for-yield will keep flows coming into high-yield, particularly since the Fed will probably keep liquidity ample. How to Invest in Credit Now While I think the fundamentals are fine for higher-quality, high-yield companies, those strong fundamentals are priced into current yields. So, you need to pick your spots. We generally like companies less vulnerable to cyclical pressures or those in which any extra yield is because of high leverage, or both. We're not fond of those whose extra yield is from high business risk. Energy is especially tough right now. Also, watch out for leveraged-buyout candidates. It's a good time to buy companies with average yields and just ride out this period of tight valuations with solid income generation.

We're Seeing Something Strange in the Credit Markets Right Now

BB- and B-rated bonds have performed well lately, but CCC-rated bonds are a different story -- this divergence hasn't happened in nearly two decades and it gives clues about what to expect for 2020.

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