Penn Capital Management Company, LLC
July 7, 2022
The credit market is giving us clues that things may be better than they seem for corporate balance sheets… either that or, it is drastically mispricing risk. We believe the former.
Those that track the “HYG” (iShares iBoxx $ High Yield Corporate Bond ETF), or another high yield market ETF, miss most of the picture. Followers of the ETF are quick to point out “credit market stress” after watching the HYG tumble this year. Yes, through June 30, the HYG is down 13.07% year-to-date; but Treasuries were down in lockstep through June 9! Indeed, most of the move higher in yields, and lower in HYG dollar price, has been the result of the underlying Treasury moves, not in credit spreads.
We believe that credit spreads are a more reliable risk indicator than absolute yields, and in the grand scheme of the high yield market history, they haven’t moved that much. Factor in resistance in the typically correlated VIX Index, and toppiness in the ICE BofA MOVE Treasury volatility index, and you might think that we are in for either a slow-down (not recession) or a recession that does not result in the typical corporate default rate and peak credit spreads of past cycles. Interest rate stability, not even lower interest rates, has gone a long way toward calming jitters; the Treasury market is now pricing at the end of the Federal Reserve (Fed) funds hikes by the end of 2022.
Looking solely at the HYG at a price of 75, one might get the wrong idea about signals from credit spreads. On June 27, 2022, with an HYG at 75, credits spreads according to the ICE BofA US High Yield Index, stood at +511. Consider that on April 1, 2020, the last time that the HYG hit 75, spreads were +911; and on January 2, 2009, also a 75 price on HYG, spreads were +1774. The other way around, consider that in early January 2015, when spreads ticked over +511 on their way to almost +900, the HYG was at 90. In other words, this time around at 75, the HYG is signaling that interest rates are higher, but not signaling corporate credit stress; those are two different things.
And it’s not energy. The energy sector, which benefits from high commodity prices and below-average spreads, is not a significant factor in pulling the entire index spread lower. At +511, if you removed energy, market spreads would move to +523. Only recently have market spreads pulled ahead of energy, the first time since 2014’s energy crisis. While this bears watching, non-energy spread levels are still not concerning.
So, why are credit spreads not higher? In part, because corporate balance sheets (for those with public not private debt) are in great shape, arguably better than they have been in any pre-recessionary cycle. The rating agency’s upgrade-to-downgrade ratio for high yield bonds (and loans) is at its highest ever, with signs of rolling over as it did in 1996, 2007, 2011 and 2019. Perhaps we are in 1996 and 2011, not 2007 and 2019.
Further, according to J.P. Morgan, ex-gaming (and leisure) and transports (mainly airlines), leverage heading into this year was at a post-Lehman low. The firm just increased its default forecast for 2023 to 1.8% for bonds and 2.3% for loans. These default levels are still benign and non-recessionary; spreads are arguably cheap to this forecast. Consider that the average default rates historically are 3+%, and recessionary default rates range from 7-13%. Therefore, spreads may be forecasting a shallower recession with shallower default rates.
So, if spreads are not projecting a “garden-variety” recession, what are the key risks that can change its mind? We believe these are: 1) an overly aggressive Fed, 2) a continued increase in aggressive issuance and 3) higher outright borrowing costs.
Aggressive issuance is often a sign of froth in the market which typically leads to a credit bubble and bust. But this year, overall issuance is down a whopping 75% versus this time last year in bonds and over 50% down in loans. Issuance for refinancing/repricing is down significantly, mainly because it had been so robust for years prior, and most debt is well termed-out. There has been an uptick in lower quality and acquisition borrowing, particularly within loans, that we believe warrants monitoring.
The outright cost of borrowing is probably the biggest risk for corporates moving forward. For the first time in a while, loan coupons should pass bond coupons this summer. The good news: bond coupons are down over 200 basis points since Pre-GFC (and locked in for an average of seven years), so the blended cost of debt is not overly troublesome in the near-term, but could become so in the next three-plus years when more debt needs to be refinanced.
The views expressed are those of Penn Capital Management Company, LLC, a boutique manager on the Spouting Rock Asset Management platform, as of July 1, 2022, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.