the Coming High Yield Downturn Will Be Big, Long, And Ugly

The US high yield market has grown larger and riskier since the financial crisis.Issuers of debt have the whip hand as buyers compete to gain an allocation in the face of surging demand from CLOs and retail funds. Companies are emboldened to seek ever weaker covenants and are taking advantage of the current conditions to borrow more at lower margins. It's as if the financial crisis never happened and the lessons from it are ancient history.

Whilst the timing of a downturn in high yield debt isn't predictable, the outcomes when it does happen are. More debt, of lower quality, with weaker covenants means the coming downturn will be bigger, longer and uglier. A quick review of some key data makes this clear.

Firstly, the size of the US high yield bond market and leveraged loan market are both close to double what they were in 2007.

Not only is the debt outstanding larger, but the credit ratings have shifted downwards on leveraged loans. Lower credit ratings mean a higher percentage of the outstanding debt will default when liquidity dries up.

The other key indicator to watch is the share of the loan market that has weak covenants. In 2007, 17% of outstanding loans were covenant-lite. Today it's over 75% with over 80% of new issuance lacking decent covenant protections. Weak covenants delay the occurrence of an event of default, which allows zombie companies to continue operating until they either exhaust their cash reserves or cannot refinance maturing debt.

High yield bulls are likely to cite the substantial equity contributions from sponsors and healthy interest coverage ratios as reasons not to be overly concerned. These are definitely much better than 2007, but these indicators do have some inbuilt weaknesses. Equity contributions are only as good as the market valuations they are based on. As US equities are arguably overpriced, sponsors are having to pay more than they historically would have to purchase a company. If price/earnings ratios revert to lower levels, company valuations will fall wiping out some of the equity cushion and making the debt a higher proportion of the enterprise value.

Interest coverage ratios are also benefitting from two deviances from historical levels. Libor has been low but is now on an upward path. For companies that have hedged, either via interest rate swaps or by issuing fixed rate debt, their protection will last for a time. For those with floating rate debt and no interest rate swaps their interest coverage ratios will generally have started to fall already due to higher Libor.

The average margin paid on top of Libor for leveraged loans is now at close to the lowest levels since 2007. When adjusted for the risk being taken, spreads are at the lowest levels since 2007. When spreads revert, issuers with near term maturities will be the first to feel the impact with higher interest bills pushing their interest coverage ratios down.

What Might the Next Downturn Look Like?

We can use the size of the high yield debt market and the probabilities implied by the current credit ratings to estimate how much debt might default. Using the historical average three year default rates we would expect over $250 billion of debt to default in the next three years. However, high yield debt default rates rarely sit at the average level with long periods below the average and short bursts way above the average. Looking back to the downturns immediately following the tech wreck and the financial crisis, those three year periods posted roughly double the average default levels. This points to the next downturn seeing over $500 billion of high yield debt defaulting.  There will be plenty of opportunities for the $74 billion of dry powder held by distressed debt funds.

However, the substantial increase in covenant-lite loans will flatten and lengthen the default cycle. Zombie companies will struggle on for longer as the lack of maintenance covenants stops lenders from forcing equity raisings, assets sales or bankruptcies that would better protect their positions. Whilst this will delay inevitable restructurings, investors will see their returns impacted far earlier as markets will reprice the debt of zombie companies to distressed levels well before the losses crystallise after a default.

The impact of covenant-lite levels on recoveries is disputed, with some historical data pointing to better outcomes achieved on covenant-lite loans. Managers often point to this data to argue that their investors have little to worry about from the growth of covenant-lite. These arguments can easily be seen as self-serving, as managers have to defend their investments in order to continue to earn their management fees. Few managers are willing to hand back capital or to substantially change strategy when conditions in their market segment are unfavourable.

Moody's takes a very different view and is forecasting an average recovery rate of 60% on first lien loans, well below the historical average of 85%. They cite more covenant-lite lending and lower levels of subordinated debt as increasing the risks for lenders. The covenant-lite loans being made today are very different from those made in 2007, which were almost exclusively made to lower risk borrowers. Today covenant-lite loans are made to both lower and higher risk borrowers with less cushion provided by second lien loans and unsecured high yield bonds.

How Should Investors Respond?

Given we know that value in US high yield debt is currently poor, there are three main options to respond; switch to cash, de-risk or change sectors.

Switch to cash: The first reaction to poor value is typically to sell out and sit in cash. As the spread in high yield debt is barely covering the average expected losses from defaults this isn't as extreme as it might seem. The increasing return on cash like investments in the US has recently risen above the dividend yield on the S&P 500. Add in the expectation of additional increases in the Federal Funds Rate and going to cash is a legitimate alternative whilst waiting for a correction in high yield debt. The lost carry of 3-4% per annum is the main downside and investors need to be prepared to pay this price for an unknown period, potentially several years.

De-risk: Switching from B and CCC rated debt to BB rated debt, selling covenant-lite loans/bonds and targeting shorter duration debt are all ways to reduce the risk but still stay invested in high yield debt. Like switching to cash, this will reduce the carry on the portfolio but the give-up is only 1-2% per annum if an investor is starting with an average portfolio. Execution of the switch may be tricky though, as there will be a very limited universe left after applying two or more of these de-risking filters. What remains will mostly be older vintage debt, which is often very tightly held.

Change sectors: Another common strategy is to give up some liquidity by shifting from public loans and bonds to private debt. The higher historical returns and stronger covenant packages would make this a very obvious shift if not for the huge amounts of capital that have flowed into private debt in recent years, competing away some of the returns. This may turn out to be a case of past returns not being a reliable indicator of future results.

For my clients, I've been implementing a switch to property debt. The pullback of the major Australian banks from investor lending, interest only loans and foreign buyers has open up a substantial gap for others. Senior loans secured by completed residential property, borrowers with substantial excess income, with low duration (2-5 years) and low LVR/LTV ratios (60-70%) are delivering net returns of around 6.50%. The illiquidity of these loans is substantially lessened by their low duration, which will see principal returned over the medium term when other credit investments are hopefully offering a better risk/return proposition. There is capacity for at least one institutional investor to put significant capital to work in this strategy.

Conclusion

US high yield debt has grown larger and riskier since the financial crisis. The combination of lower ratings and covenant-lite lending points to the next downturn being longer and having lower recoveries with over $500 billion of defaults likely. Investors are currently receiving minimal spread over historical average loss levels making the status quo an unattractive position. Switching to cash, de-risking portfolios or changing sectors are all legitimate ways to reposition portfolios with a view to reinvesting at lower prices in the medium term.

"The ECB Is Basically Giving The Finger To Italy": Is Draghi Risking Everything To Teach Rome A Lesson

Perhaps the most perplexing market-moving event of the past 48 hours, was the 1-2 punch of a Tuesday Bloomberg report that next Thursday's ECB meeting is "live" in that policy makers anticipate (at long last) holding a discussion that could conclude with a public announcement on when they intend to cease asset purchases (QE), coupled with a slew of ECB members overnight coming out with unexpectedly hawkish comments.

Of these, the ECB's otherwise dovish Peter Praet said inflation expectations are increasingly consistent with the ECB's aim, and added that markets are expecting an end of QE at end of 2018, this is an observation and input that is up for discussion and that "it's  clear that next week the Governing Council will have to make this assessment, the assessment on whether the progress so far has been sufficient to warrant a gradual unwinding of our net asset purchases."

Other ECB hawks such Hanson, Weidmann and Knot doubled down on the central bank's sudden QE-ending jawboning pivot, saying that the ECB could lift rates before mid-2019 due to "moderately" rising inflation, that market expectation of end of QE by end of 2018 is plausible, and that the ECB should wind down QE as soon as possible.

The market response was instant, and it not only pushed both German and Italian yields sharply higher...

... as well those of US Treasurys, but spiked the EUR while sending the USD lower, and unleashing today's euphoric stock surge.

Now, it is hardly rocket surgery that without ECB support, Italian bonds are toast. After all,as we have shown and predicted since last December, without the only marginal buyer of Italian debt for the past 2 years - the ECB - Italian yields would soar, leading to a prompt default by the nation which would suddenly find itself drowning under untenable interest expense.

This was indirectly confirmed earlier this week, when the ECB admitted that, for whatever stated reason, it had purchased a far smaller share of Italian bonds than normal. In fact, in May the ECB bought the smallest relative percentage of Italian debt since the launch of QE...

... while boosting its Bund purchases.

Needless to say, the Italians, especially the ruling populist coalition, were furious and claimed that Draghi was directly "manipulating" the market to slam Italian bonds and hurt public sentiment just as the coalition was being formed and threatened to place a Euroskeptic finance minister, something EU budget commissioner scandalously suggested last week when he said that "the negative development of the markets will lead Italians not to vote much longer for the populists", a terrible statement for which he promptly apologized as it was... the truth, and revealed that fundamentally the ECB is very much a political entity, and one which got Silvio Berlusconi fired in November 2011 in precisely the same way.

Still, the irony is that beyond the obvious Italian anger at the realization that the nation with the Eurozone's biggest debt load remains an ECB puppet (and on daily life support courtesy of Mario Draghi), the real question was: so what? As we said on Monday:

"yes, Italian bonds are massively mispriced and they will plunge if and when the ECB stops supporting the market, in effect holding Italy hostage. As for the biggest question, it is what if anything, Rome has up its sleeve to avoid such a fate when Draghi's QE finally ends."

The answer, sadly for Rome, remains absolutely nothing, as without the backstop of the ECB's "whatever it takes" policy to keep the Eurozone together, the Eurozone would almost instantly fall apart (which ironically would be a welcome development for Italy, at least in part, as it would allow it to default on its debt in its own currency).

And that is what many believe was what prompted the ECB's strange spectacle over the past 48 hours: the hawkish twist and the barrage of QE-ending comments by ECB members was nothing more than a lesson to Italy, demonstrating what will happen i) if Italy were threaten with leaving the Euro and ii) when QE finally ends... at some indefinite point.

Or, as Bloomberg's Lisa Abramowicz said in a podcast today,  it was the ECB "basically just giving the finger to Italy."

Confirming as much, Anne Mathias, Global Rates and FX strategist for Vanguard, responded that "part of the vocal nature of the 'talking about the talking about' [the end of QE] probably has something to do with Italy, especially as they've been paring their purchases of Italian debt. What the ECB is trying to say is hey, "this is our party, and you're welcome to it, but if you're going to leave it's not going to be easy for you." The ECB is trying to show Italy a future without the ECB as backstop."

A spot-on follow up question from Pimm Fox asked if this is "a situation in which the ECB is cutting off its nose to spite its face, because you can stick to rules for the sake of sticking to rules, but when you have a potential crisis, why wait for it to be a real crisis such as Italy, which the new government has pledged to spend a lot of money, to lower taxes, while they still have a huge government deficit. Why would the ECB do this."

The brief answer is that yes, it is, because sending the Euro and yields higher on ECB debt monetization concerns, only tends to destabilize the market, and sends a message to investors that the happy days are ending, in the process slamming confidence in asset returns, a process which usually translates into a sharp economic slowdown and eventually recession, or even depression if the adverse stimulus is large enough.

As for the punchline, it came from Abramowicz, who doubled down on Pimm Fox' question and asked if the "European economy can withstand the shock" of the ECB's QE reversal, which would send trillions in debt from negative to positive yields.

While the answer is clearly no, what is curious is that the ECB is actually tempting fate with the current "tightening" scare, which may send the Euro and bond yields far higher over the next few days, perhaps even to a point where Italy finds itself in dire need of a bailout... from the ECB. Then again, don't be surprised if during next Thursday's ECB press conference, Mario Draghi says that after discussing the end of QE, no decision has been made or will be made for a long time. At that moment, watch as the EUR and bond yields tumble, and the dollar resumes its relentless push  higher.

Why the Eurozone and the Euro Are Both Doomed

Papering over the structural imbalances in the Eurozone with endless bailouts will not resolve the fundamental asymmetries.

Beneath the permanent whatever it takes "rescue" by the European Central Bank (ECB) lie fundamental asymmetries that doom the euro, the joint currency that has been the centerpiece of European unity since its introduction in 1999.

The key imbalance is between export powerhouse Germany, which generates huge trade surpluses, and its trading partners, which run large trade and budget deficits, particularly Portugal, Italy, Ireland, Greece and Spain.

Those outside of Europe may be surprised to learn that Germany's exports are roughly equal to those of China ($1.2 trillion), even though Germany's population of 82 million is a mere 6% of China's 1.3 billion. Germany and China are the world's top exporters, while the U.S. trails as a distant third.

Germany's emphasis on exports places it in the so-called mercantilist camp, countries that depend heavily on exports for their growth and profits. Other (nonoil-exporting) nations that routinely generate large trade surpluses include China, Japan, Germany, Taiwan and the Netherlands.

While Germany's exports rose an astonishing 65% from 2000 to 2008, its domestic demand flatlined near zero. Without strong export growth, Germany's economy would have been at a standstill. The Netherlands is also a big exporter (trade surplus of $33 billion) even though its population is relatively tiny, at only 16 million.

The "consumer" countries, on the other hand, run large current-account (trade) deficits and large government deficits. Italy, for instance, has a $55 billion trade deficit and a budget deficit of about $110 billion. Total public debt is a whopping 115.2% of GDP.

Spain, with about half the population of Germany, has a $69 billion annual trade deficit and a staggering $151 billion budget deficit. Fully 23% of the government's budget is borrowed.

This chart illustrates the dynamic between mercantilist and consumer nations:

Although the euro was supposed to create efficiencies by removing the costs of multiple currencies, it has had a subtly pernicious disregard for the underlying efficiencies of each eurozone economy.

Though German wages are generous, the German government, industry and labor unions have kept a lid on production costs even as exports leaped. As a result, the cost of labor per unit of output -- the wages required to produce a widget -- rose a mere 5.8% in Germany in the 2000-09 period, while equivalent labor costs in Ireland, Greece, Spain and Italy rose by roughly 30%.

The consequences of these asymmetries in productivity, debt and deficit spending within the eurozone are subtle. In effect, the euro gave mercantilist, efficient Germany a structural competitive advantage by locking the importing nations into a currency that makes German goods cheaper than the importers' domestically produced goods.

Put another way: By holding down production costs and becoming more efficient than its eurozone neighbors, Germany engineered a de facto "devaluation" within the eurozone by lowering the labor-per-unit costs of its goods.

The euro has another deceptively harmful consequence: The currency's overall strength enables debtor nations to rapidly expand their borrowing at low rates of interest. In effect, the euro masks the internal weaknesses of debtor nations running unsustainable deficits and those whose economies had become precariously dependent on the housing bubble (Ireland and Spain) for growth and taxes.

Prior to the euro, whenever overconsumption and overborrowing began hindering an import-dependent "consumer" economy, the imbalance was corrected by an adjustment in the value of the nation's currency. This currency devaluation would restore the supply-demand and credit-debt balances between mercantilist and consumer nations.

Absent the euro today, the Greek drachma would fall in value versus the German mark, effectively raising the cost of German goods to Greeks, who would then buy fewer German products. Greece's trade deficit would shrink, and lenders would demand higher rates for Greek government bonds, effectively pressuring the government to reduce its borrowing and deficit spending.

But now, with all 16 nations locked into a single currency, devaluing currencies to enable a new equilibrium is impossible. And it leaves Germany facing with the unenviable task of bailing out its "customer nations" -- the same ones that exploited the euro's strength to overborrow and overconsume. On the other side, residents of Greece, Italy, Spain, Portugal and Ireland now face the unenviable effects of government benefit cuts aimed at realigning budgets with the productivity of the underlying national economy.

While the media has reported the Greek austerity plan and EU promises of assistance as a "fix," it's clear that the existing deep structural imbalances cannot be resolved with such Band-Aids.

Either Germany and its export-surplus neighbors continue bailing out the eurozone's importer/debtor consumer nations, or eventually the weaker nations will default or slide into insolvency.

Germany helped enable the overborrowing of its profligate neighbors by buying their government bonds. According to BusinessWeek, German banks are on the hook for almost $250 billion in the troubled eurozone nations' bonds.

Now an inescapable double-bind has emerged for Germany: If Germany lets its weaker neighbors default on their sovereign debt, the euro will be harmed, and German exports within Europe will slide. But if Germany becomes the "lender of last resort," then its taxpayers end up footing the bill.

If public and private debt in the troubled nations keeps rising at current rates, it's possible that even mighty Germany may be unable (or unwilling) to fund an essentially endless bailout. That would create pressure within both Germany and the debtor nations to jettison the single currency as a good idea in theory, but ultimately unworkable in a 16-nation bloc as diverse as the eurozone.

Be wary of endless "fixes" to a structurally doomed system.