As indicated in Moody’s 2018 Annual Defaults Report, recent default rates on corporate debt have been significantly below long-term historical averages. Is this as positive for forward returns as one would think?

This week’s chart of the week shows recent corporate default rates against the longer-term averages and the return/risk ratio. As expected, the default rates are lower across the board and especially so in the sub-investment grade space. B rated debt has the largest change in default rate at 9.3%, leaving the trailing 5-year default rate at nearly half of its longer-term average. Lower default rates have been great for returns, so what’s the risk?

Just as equity analysts extrapolate recent high company earnings growth into the future, the risk is that credit analysts extrapolate the unordinarily low default rate into the future. The recent economic environment has been hospitable for low default rates with steadily increasing corporate margins and an increased ability to pay down debt. As some investors move into more volatile and lower quality debt to chase the higher yield that these bonds offer, the return per unit of risk decreases because the default rate increases by more than the additional yield benefit. If default rates were to increase and revert to the mean, lower credit rating bonds would be hit especially hard.

However, active investment managers strive to mitigate some of these risks. They can tilt their portfolios to higher quality bonds or choose bonds that they believe are rated incorrectly by rating agencies, thus lowering their portfolio’s default rate. In total, the recent low default rates have been great for trailing returns, however the future environment is uncertain and the strategy of reaching for higher yield may not perform as it has in recent history.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

This week’s chart looks at two key indicators of the health of the U.S. credit market. The first, on the left, shows a growing portion of covenant-light (“cov-lite”) bank loans relative to full-covenant bank loans.¹ The second indicator, on the right, shows a growing portion of loan-only bank loan issuers, which remove the benefit of a credit cushion for bank loan investors.² Recent studies by Credit Suisse show that recovery rates for cov-lite issuers are 10-15% worse than non-cov-lite issuers, and recovery rates for loan-only unitranche issuers are 15% worse than non-unitranche issuers. As such, there is some structural deterioration in the bank loan market, but the general consensus is that this should not be a 2019 story, but 2-3 years out. This means that there is not a very high concern of a credit crunch in 2019, but potentially in 2020-2021 if prices get to frothy levels again by then.

That said, defaults remain low, so at least for now, there is no sign of immediate trouble. And spreads have widened out over the last couple of months to be wider than average excluding 2008 and 2009 levels, showing that there has been some release in pressure and the market is perhaps pricing in some of these concerns. Most bank loan strategies are now focused on quality credit selection, avoiding deals with high leverage and unreliable assets or unreliable earnings. That said, as this cycle wears on, we would certainly want to remember that despite their senior secured nature, bank loans are still sub-investment grade debt and should be balanced with a healthy core bond allocation.

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¹ Covenant-light means that the bank loan issuer is subject to few restrictions, also known as covenants, in managing its business. For example, covenants could be maximum leverage (debt divided by cash flows) or minimum coverage (cash flows divided by interest expenses). The rise in cov-lite deals has been a reality since 2005 and they appear to be here to stay. One reason for their rise is due to the standardization and syndication of bank loans as a public security, thereby making them become more like high yield bonds, which have very little covenants, and less like private credit.

² This means that, in the event of bankruptcy, the bank loan investors do not have a high yield, junior subordinated debt tranche beneath them for the losses to eat into after the equity tranche. The bank loan investors will see immediate losses right after the equity tranche in this case.

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.