Big Reset Looms for Corporate Credit Market

Market still blows off Fed, Treasury selloff, and volatility in stocks.

"Leveraged loans," extended to junk-rated and highly leveraged

companies,are too risky for banks to keep on their books. Banks

sell them to loan mutual funds, or they slice-and-dice them into

structured Collateralized Loan Obligations (CLOs) and

sell them to institutional investors. This way,the banks get 

the rich fees but slough off the risk to investors, such as

asset managers and pension funds.

This has turned into a booming market. Issuance has soared. And

given the pandemic chase for yield, the risk premium that investors

are demanding to buy the highest rated "tranches" of these CLOs has

dropped to the lowest since the Financial Crisis.

Mass Mutual's investment subsidiary, Barings, has packaged leveraged

loans into a $517-million CLO that is sold in "tranches" of different risk levels.

The least risky tranche is rated AAA. Barings is now selling the

AAA-rated tranche to investors priced at a premium of just 99 basis

points (0.99 percentage points) over Libor, according to S&P Capital,

cited by the Financial Times.

Also this week, New York Life is selling the top-rated tranche of a CLO

at a spread of less than 100 basis over Libor. And Palmer Square Asset

Management sold a $510-million CLO at a similar premium over Libor.

In the secondary markets, where the CLOs are trading, red-hot demand

has already pushed spreads below 100 basis points. These are the

lowest risk premiums over Libor since the Financial Crisis.

These floating-rate CLOs are attractive to asset managers in an

environment of rising interest rates. If rates rise further, Libor rises

in tandem, and investors would be protected against rising rates by

the Libor-plus feature of the yields.

Libor has surged in near-parallel with the US three-month Treasury

yield and on Monday reached 1.83%. So the yield of Barings CLO

was 2.82%. While the Libor-plus structure compensates investors

for the risk of rising yields and inflation, it does not compensate 

investors for credit risk!

These low risk premiums over Libor are part of what constitutes

the "financial conditions" that the Fed has been trying to tighten

by raising its target range for the federal funds rate and by unwinding

QE. It's supposed to make borrowing a little harder and a little more

costly in order to cool off the credit party.

One of the measures that track whether "financial conditions" are

getting "easier" or tighter is the weekly St. Louis Fed Financial

Stress Index. In this index, zero represents "normal." A

negative number indicates that financial conditions are easier

than "normal"; a positive number indicates that they're tighter than

"normal."

The index, which is made up of 18 components – including six

yield spreads, including one based on the 3-month Libor – had

dropped to a historic low of -1.6 on November 3, 2017. Despite

the Fed's rate hikes and the accelerating QE Unwind, it has

since ticked up only a smidgen and remains firmly in negative

territory, at -1.35.

The Financial Stress Index and the two-year Treasury yield usually

move roughly in parallel. But since July 2016, about the time the

Fed stopped flip-flopping on rate hikes, the two-year yield began

rising and more recently spiking, while the Financial Stress Index 

initially fell.

The chart below shows this disconnect between the St. Louis 

Fed's Financial Stress Index (red, left scale) and the two-year

Treasury yield (black, right scale). Note the tiny rise of the red

line over the past few weeks (circled in blue):

The horizontal blue line marks zero of the Financial Stress

Index (left scale). At or above zero is where I — after 

reading the tea leaves — think the Fed would like to

see the index at this point. But the index is far from it.

And the CLOs mentioned above are examples of just how

ebullient corporate credit markets still are at every level.

A similar ebullience is still visible in junk bonds as well.

The corporate credit markets are starting to take into

account the risk of slightly higher inflation – hence the

appetite for these floating-rate CLOs. But the risk

premium over Libor and other risk premiums show

that credit markets are still totally in denial about 

the bigger risk for junk-rated credits: the risk of default.

And this risk of default surges when rates rise and 

financial conditions tighten as these companies have

trouble refinancing their debts when they come due.

But for now, investors are blithely ignoring that they're

in for a big reset.

The chorus for more rate hikes is getting louder. But

no one will be ready for those mortgage rates.