January 1, 2014 7:00 pm
2014 outlook: Sugar high
‘Credit Cassandras’ say strong demand for risky bonds is a sign of frothy markets.
As snow fell in New York City on a December afternoon, waiters bearing trays of cookies fanned out among the group of bankers and investors gathered at the New York Athletic Club. The sweet biscuits were courtesy of Leonard Tannenbaum, chief executive of Fifth Street Management, who had a message for those attending the financial conference.
“I believe there’s another cycle coming,” said Mr Tannenbaum, whose specialist lending firm enjoys the support of investor David Einhorn. “So have the cookie. I want you to enjoy the sugar high – while it lasts.
US credit markets rebounded in 2013 as a flood of central bank money and continued low interest rates pushed investors into riskier but higher-yielding assets.
While many see the resurgent demand for riskier loans and bonds as a natural effect of a nascent US recovery, others – such as Mr Tannenbaum – see it as evidence of a bubble blown by central banks.
To the sceptics, the market is experiencing the kind of frothiness seen before the 2008 financial crisis. This, too, will end in tears, they warn.
Perhaps the foremost of these “credit Cassandras” is Jeremy Stein, the US Federal Reserve governor who warned in February that markets may be overheating. “A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield’,” he said, flicking through slides of warning signals. Since then, those warning signals have flashed ever brighter.
Issuance of syndicated leveraged loans – those made to companies that already carry high debt loads – reached $535.2bn in 2013. That is just shy of the $604.2bn sold in 2007, at the height of the last credit bubble. Meanwhile, loans that come with fewer protections for lenders, known as “covenant-lite”, accounted for almost 60 per cent of loans sold in 2013, compared with a 25 per cent share in 2007.
“There are no bargains in fixed income. We have seen a return to a lot of the practices that made people nervous in 2007 such as PIKs and cov-lite,” says Russ Koesterich, chief investment strategist at BlackRock.
Sales of “junk”, or high-yield, bonds surged to a record in 2013 as companies rushed to refinance and investors snapped up the resulting assets. Issuance of junk bonds rated “triple C” – the lowest designation – jumped to $15.3bn, surpassing the pre-crisis peak.
“There are early warning signs of excess in the high-yield bond market with the heavy issuance of triple C rated debt,” says Edward Marrinan, of RBS Securities.
Others cite reasons for optimism. They note that credit “spreads”, or the additional returns investors demand to hold riskier credit assets, are not yet near the historic lows experienced in the run-up to the 2008 crisis. That suggests investors are differentiating between riskier assets and relatively safe securities, such as US government debt.
In contrast to 2007, the current average junk bond yield of 5.6 per cent is far higher than the yield on offer from the five-year Treasury note, at a difference of about 423 basis points. In June 2007, this spread had narrowed to a record low of 238 bps.
The argument against a bubble forming in the market at the moment is that overall credit remains abundant, enabling companies to roll over their funding, notes Mr Koesterich. “Companies can still raise money, so there is no financing risk.”
But investors who are concerned about the warning signs simmering in the credit markets may not be able to avoid investing in risky asset classes. For many, the pressure of reaching their “bogeys” – the benchmarks used to evaluate returns – is enough to justify the acquisition of riskier credit assets, particularly given the lack of yield on safer investments.
Since 2008 regulators have enacted rules that have herded some of the largest investors into high-quality bonds to reinforce the financial system. At the same time, the Fed’s policy of quantitative easing has led it to buy $85bn of US government debt a month, taking trillions of dollars of fixed income assets out of circulation.
Despite continued strong sales of corporate and government bonds, the central banks’ big purchases mean annual net issuance of financial assets is hovering around $1tn – far lower than the $3tn-$4tn sold in the years before the crisis, according to data compiled by Citigroup.
“We are removing a significant number of high-quality bonds from the system and that requires replacement, and that replacement can only be found at a higher spread and that requires higher risk,” says Jason Shoup, a Citi analyst.
Wall Street’s securitisation machine is shifting into gear to help make up for some of the lack of supply. The kind of subprime mortgage-backed securities that played a starring role in the mid-2000s housing boom have largely disappeared. But other “sliced and diced” securities have come back.
Demand for many securitisations has been almost insatiable, with bankers who structure them claiming they have to walk a tightrope between investor demand and the actual need for credit in the “real world” economy.
“There are still investors who ask us ‘why doesn’t the issuer upsize the deal?’,” a senior banker says of recent securitisations that bundle together loans used to finance car sales. “The answer is because you would have to sell more cars.”
For investors still scarred by the financial crisis, the question is whether credit markets have been recovering to something like a normal state or entering yet another credit bubble. For many, the answer is obscured by easy money from the Fed.
“Yes, we fear the market is being distorted by the central banks but we expect them to do more. That’s something we need to live with,” says Matt King, a Citi strategist.
Mr Tannenbaum’s advice to the bankers is to do “lots of deals” soon – and if changing jobs, be sure to lock in a three-year contract.
Copyright The Financial Times Limited 2014.