Overview: In a year when credit markets have come under pressure on numerous occasions, an analysis of the details highlights areas of stress — and pockets of opportunity — heading into 2016.
Economic: Credit market weakness in the U.S. was certainly a headline worry last week, as a couple of funds were forced into headline-grabbing liquidation mode (it’s typically not sound trading practice to announce to the world what you intend to do before you do it). This weakness, however, was very concentrated in the high yield and loan markets — investment grade credit, while modestly weaker, was not affected nearly as badly.
Some combination of impaired liquidity conditions for corporate bonds broadly, retreating commodity prices (especially oil), and fears of how markets would react to the Fed liftoff all played a role, but as commodity prices at least stabilize and with the Fed liftoff having gone relatively smoothly, credit markets seem to have found their footing again. For context, at its worst, some high yield metrics were implying default rates roughly equivalent to those experienced during and shortly after the great financial crisis — and U.S. macroeconomic conditions obviously are far from those levels.
Quantitative: After underperforming high yield markets for the majority of the first half of the year, investment grade credit has significantly outperformed its riskier counterpart since mid-year, gaining more than 8% in less than six months. Much of the underperformance in high yield has come from this market’s exposure to the energy sector, which accounted for as much as 17% of the market prior to 2015, but now only accounts for 11% of the high yield market.
In the aggregate, credit markets have lagged the broader fixed income market on the year as the Fed’s slowness in raising interest rates led to outperformance for Treasuries which saw rates come down from 2014 levels. However, the Fed’s decision to raise interest rates following the December meeting could reverse this trend as historically credit has outperformed Treasuries as rates increase.
Fundamental: Corporate earnings have come under scrutiny in recent weeks as data was published stating that the percent of North American companies losing money is at its highest level since 2009. Additionally, it was reported that the ratio of these companies that are losing money is massively out of line with the default rate, indicating a disconnect in credit markets — signalling a potential for a wave of credit events not seen since the great financial crisis.However, this fear may be unwarranted due to companies holding significant amounts of cash on their balance sheets.
Upon further inspection, nearly half of these companies with negative earnings have more cash than total debt, considerably mitigating credit concerns. It’s also important to understand that many companies have adopted a business model where management invests profits back into the business, thus posting losses that would otherwise be returned to shareholders, in hopes the market will reward them with a generous valuation. This strategy, while unconventional relative to historical standards, also speaks to a healthier corporate environment than metrics would have many believe.