Aberdeen Standard Investments spoke to its fixed income team and learned what will be different in the credit cycle this time around.
The world has experienced a long credit cycle since the global financial crisis of 2008–2009. The expansionary phase of the cycle has been extended by global central banks’ quantitative easing.
Although bonds have appreciated, tight spreads have made yield difficult to find. This presents a challenging environment for investors.
We asked our fixed income team what’s different about this credit cycle, and what investors should look for as they invest in this uncertain environment. It’s likely that credit conditions will start to deteriorate before long, making it harder to find bonds with attractive potential for appreciation. An increase in inflation could also hurt insurers’ returns.
Rising rates will pose a challenge that will ultimately create opportunity. Regulatory and secular changes may provide some attractive spaces to ride out the storm. On the other hand, some strategies that have worked in past downturns might prove less rewarding this time.
Q. When will the credit cycle shift from expansion to downturn, and how bad will the downturn be?
A. Our expectation is that it will happen in the next 12 to 24 months, as European and Japanese central banks join the U.S. in tightening monetary policy. We believe the downturn for credit markets is likely to be less severe than during the global financial crisis as this cycle is likely to be more driven by the slowdown in economic opportunity than by limited liquidity.
It is also likely to be longer than the post-crisis downturn, just as the current expansion has been long. Think more about the credit downturn of the 1999 recession, rather than 2008 to 2009.
Q. What differences about this cycle affect where you find investment opportunities and risks?
A. The biggest positive is that the U.S. financials sector is stronger than in earlier credit downturns, due to stricter regulations. That includes the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Capital and liquidity requirements are significantly tighter than they were before the global financial crisis. The soundness of banks in this cycle will prevent a loss of liquidity for U.S. companies and a sharp escalation of defaults.
We see financials as a potential winner in the next phase of the credit cycle. Financial firms have run with less leverage during this cycle. That puts them in a better position to weather the tightening of credit that will come in the next part of the cycle. That’s especially true if they have sound liquidity.
Within financials, we particularly like major U.S. banks. That’s because they boast diversified businesses, have improved risk controls since the financial crisis, and rely more on deposits instead of wholesale funding.
They are positioned to benefit from the Trump administration’s easing of the rigid rules established after the global financial crisis. The rigidity of post-crisis regulations is no longer needed.
Some easing is promising for prudent growth because it will help reduce excess costs related to regulation and return the banks to their core mission of taking in deposits and making loans. Stripping away some of the vestigial, extraneous elements of oversight will benefit the banks and boost growth, though not at the expense of the balance sheet.
As long as governors of capital and liquidity stay in place—and, we are confident they will—banks and bondholders will be better served by fewer obsolescent regulations.
Q. What about opportunities in different parts of the U.S. credit curve?
A. We also see less risk of a drawdown in the 3-year to 5-year part of the investment-grade credit curve. These bonds benefit from a still-steep credit curve, attractive all-in yields, and less vulnerability to loss of foreign demand.
We also like higher-quality high yield and high yield bonds with less than five years to maturity.
We think the long end of the U.S. credit curve will see offsetting demand. Foreign investors may find less value in 30-year corporate bonds, due to higher hedging costs, while U.S. pension buyers should be a strong source of demand amid higher overall yields.
Q. What other sectors have been affected by regulatory or fundamental change since the last credit downturn?
A. Elsewhere, companies that have benefited from secular changes in the U.S. economy also have the potential to perform relatively well. One example is energy infrastructure, such as pipelines and refiners. These companies satisfy the need to refine and transport more oil drilled in the U.S.
They benefit from relative financial strength, as well as demand for their products and services. Most of the energy infrastructure companies adopted conservative financial policies during the downturn in oil prices during 2015 and 2016, moderating or cutting distributions, selling non-core assets and/or raising equity.
These conservative policies remain in place. In addition, most recent and new infrastructure projects are supported by long-term fee-based contracts that include some form of minimum commitment or demand charges.
Structural changes and increased competition from new entrants has increased risks in some sectors. This is especially true of the telecom/cable/media companies that are threatened by new entrants and new technology. This includes small business/enterprise telecom, wireline, video distribution, some content creators and hardware producers, and satellite distribution. Media properties that rely too much on advertising revenues to generate cash flows are also at risk.
However, there are some technology, media, and telecom companies that may do relatively well. For example, there may be opportunities in cable/fiber-fed broadband, telecom infrastructure providers, established software franchises that enjoy stable cash flows from recurring revenues, and interactive gaming companies, as consumers globally are likely to continue gaming, regardless of the economic environment.
We also see risks to consumer-oriented industries, such as retailers, where many companies struggle to compete with Amazon.
Q. What other factors affect opportunities and risks?
A. Issuance is an important factor. During the credit expansion, U.S. BBB rated debt grew significantly, thanks to M&A and shareholder-friendly actions. As a result, the BBB/BB part of the market will come under more pressure, compared with prior credit downturns, as more debt will be at risk to be downgraded from investment grade to high yield.
This may be particularly true of companies, such as consumer-oriented and healthcare companies that have issued a lot of debt to fund M&A. Rating agencies may be slow to act, but they will act eventually. Credit selection will be critical with the names and sectors that used debt to fund M&A. The key will be identifying companies that have the ability to de-lever with free cash flow or asset sales, and avoiding names that can’t de-lever due to competitive pressures or secular changes in their industry.
On the flip side, sectors where we’ve had less issuance during the credit cycle’s expansionary phase are poised to fare better. This includes subordinated U.S. financials and higher-quality high yield bonds.
Looking at specific types of securities, investors’ quest for yield has encouraged looser terms and weaker underwriting for some types of lending. This is especially true of leveraged loans, private market debt, and student loans.
Q. How might structured credit fare in a downturn?
A. If volatility continues to ramp up and rates move significantly - either up or down - the best opportunity will be agency mortgages. Agency Mortgage Backed Securities (MBS) outperform other credit in periods of economic stress: such was the case in 2001-2002, 2008 and 2011-2012.
They offer good diversification vs investment grade corporate bonds and represent one of the best defensive plays in a downturn/higher rate scenario.
Beyond Agency MBS there are a few sectors that should prove attractive in a downturn. Legacy non-agency paper, while harder to source, is now floating rate and offers loss adjusted yields in the 4-4.5% area with little to no interest rate duration.
In the event of a downturn the robust home price appreciation over the last five years will minimize the severity and impact of any delinquencies and defaults. Newer-issue short non-agency paper also is attractive.
Despite a recent softening of underwriting standards they are still tighter (more conservative) than they were heading into the 2008 recession.
The higher credit enhancement and 2-3 year average lives on these securities should allow them to withstand any downturn and still provide 4% yields to investors. Lastly, select short dated (2 – 3 year) opportunities in the ABS market offer good relative value opportunities.
Q. Do the world’s trade tensions influence where you see opportunities and risks?
A. Trade tensions are higher now than they have been during previous credit cycles. Companies with substantial overseas operations sensitive to rising trade tensions—for example, autos and chemicals, may be losers.
Conversely, companies with a domestic U.S. focus, such as utilities, may fare relatively well.
Q. What about the influence of central bank tightening?
A. Central banks’ accommodative policies have buoyed fixed income markets since the global financial crisis. But, times are changing. When Europe and Japan join the U.S. in tightening, that will pressure valuations. Long-duration investment-grade credit may be vulnerable to loss of foreign demand as rates rise globally with central bank tightening.
Compared with prior credit downturns, changes in the technical support of the market will weigh more on valuations of those sectors/names whose fundamentals are vulnerable. We’re referring to the fact that major banks and brokers have smaller balance sheets, limiting their ability to provide liquidity to support markets during periods of stress.
Q. What wild cards might affect your predictions?
A. The unprecedented scale of central banks’ quantitative easing makes it difficult to look to history for suggestions of how the credit cycle will unfold. The markets can always work in unexpected ways. For example, reduced supply and pension buyer demand may help the 30-year part of the credit curve.
Trade war fears may be overblown, which would lead to trade-sensitive sectors outperforming. The U.S. economy may be stronger than expected, which would help cyclicals and lower-quality high yield. Or, conversely, a U.S. recession would help returns of bonds rated A or higher.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks. Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.