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May 12, 2014

Will the search for yield come to tears? Eventually yes, but probably not in 2014

When one of  the largest issuers of sub-investment grade credit publicly expresses concerns about the market becoming very frothy again, investors should maybe take notice. Marc Rowan, Co-founder of Apollo, declared recently at the Milken Institute Global Conference  „All the danger signs are there of a future crisis. We’re back to doing exactly the same things that were done in the credit markets during the last crisis.“(1)

The key driving factor behind future returns of corporate credit is the default rate. Currently the default rate is extremely low – however, this should not come as a surprise as historically the default rate five years following the most recent crisis tends to be lower than the historical average.

Moodys 5y after default spike - default rate lower than 5y average

Like Apollo, we don’t just focus on today’s default rates but we also look at the seeds of default. What are the key drivers for the future default rate?

  1. New issue quality. Higher new issue quality leads to lower default rates. Are credit documents increasingly in favour of investors or issuers?
  2. Balance sheet. Lower leverage improves you chances as an investor to see a return of capital and not just a temporary return on capital.

New issue quality starting to deteriorate

Today we witness in the US credit markets exactly the same behaviour as during the previous run-up to the crisis: covenants being stripped away, cov-lite loans the norm again, higher leverge of senior debt than 2007, etc. We are not looking at an immediate spike in defaults. The question is just how and when. Is it any better in Europe? Clearly not, as the new issue market here shows the same frothiness:

  • Only 18% of new issues in April were BB rated vs 56% in Q1
  • 54% of new issues in April were for releveraging (dividends and M&A) vs 15% in Q1
  • We have now seen €19.0bn of releveraging transactions YTD vs €20.9bn for the whole of last year and look on target to surpass the record of €23.7bn set in 2006.

Balance sheets taking a turn for the worse with leverage near non-recessionary high

Since 2011, net leverage (net debt to EBITDA) of European corporate credit issuers has increased significantly. Outside of recession, leverage has seldom, if ever been higher in the European credit market.

Citi leverage in Europe

Effects of future sell-offs will be amplified by poor liquidity

Investors who think that they will be able to easily exit their credit positions once they see the first sign of fundamental deterioration probably have not fully taken into account the structural changes this market has undergone since the last crisis. There were basically no High Yield and bank loan ETF in 2008 – now those financial products have proliferated and give easy access to credit investments. However, while ETF hold the promise of instant access to liquidity, the underlying assets often are far less liquid. In addition, there is now much less dealer inventory that can act as a buffer as a result of tougher banking regulations. What happens when the investors that have been playing tourist in riskier assets classes than they are used to as they were searching for yield decide to go home? Chances are they will realize that the exit door is too small for all. We therefore expect increased volatility going forward in credit.

HY no exit with declining inventory


What’s an investor to do that still wants some exposure to this asset class?

  • The beta trade is over. Simply buying the index no longer works as the yield-to-worst is currently only around 4%. In this environment, we prefer actively managed funds to ETF.
  • You need to do your homework when choosing an active credit fund – avoid benchmark huggers. Also, the European High Yield market has nearly tripled in size in the last 6 years and you need to be sure the fund manager has enough dedicated resources.
  • We would also look at credit hedge funds which can invest in non-corporate credits (like RMBS).
  • For investors who have a more bullish outlook on the corporate credit market than ourselves and who are not risk averse, we would recommend looking at alternative asset managers that focus on the credit market. In some cases, the divided yield of those publicly traded equities are higher than the available returns on the High Yield credit market.

For further questions, please contact us at info@ipanema-capital.com

The author worked more than 6 years on the High-Yield desk of one of the leading new issue houses in London.


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