Over the summer, rising rates threatened to drain liquidity and easy money from the financial markets. Now, as the year ends, economists are fixated on the horrible US housing market and debating whether the economic landing will be hard or soft.
It’s all bad news for credit… and yet.
And yet, credit spreads have ground in all year. Why? Because most investment-grade corporates are in very rude financial health. Profits are strong, spending on capex or M&A has not risen at an alarming rate, cash and liquidity is high. Investors and lenders want to put on assets.
So it is important to remember, though, that the day of reckoning has not been averted: it has merely been delayed. Even though shorting credit this year has generally been a costly mistake, with spreads now once again at or close to historically tight levels, valuations rich, the economic outlook uncertain, announced M&A and LBO volumes rising, the only thing harder to be than a credit bear is a credit bull.
When the inevitable blow-ups come, common sense would suggest that it will be the weaker, more highly leveraged credits that explode first, especially if the economic slowdown is worse than expected, earnings decline sharply and equity markets turn volatile and weak.
In the late summer, Standard & Poor’s listed 653 credits at risk of downgrade, mainly in the US and Europe. Of these, more than 60% are already speculative grade, with 123 of those on ratings watch or negative outlook being in the single-B category.
Adding to the sense of uncertainty, Fitch Ratings released a study of how weakening covenant packages in documentation for loans taken on by borrowers in a strong credit market in the first half of 2006 have eroded one of the market’s traditional early warning systems. It finds that this deterioration in covenant packages has been most striking in the non-investment -grade part of the market.
On average, interest coverage ratio covenants have been included in 50% of all non-investment-grade loans over the period 1996 to 2006. But in the first half of 2006, they appeared in just 35% of such loans. The frequency of occurrence of any type of financial ratio covenant fell to 61% of such loans in the first six months of this year, down from an average of 78% over the past 10 years.
The process by which borrowers in the first stages of financial difficulties approach banks to request waivers on maintenance of key financial covenants is a trustworthy lead indicator for an imminent outbreak in more severe restructurings and defaults. Right now, anecdotal evidence suggests the incidence of such waivers is rising and coming earlier in the life of financings. Watering down these covenants or dropping them altogether both weakens the warning system for when the credit cycle turns south and removes restraints on borrower behaviour, Fitch suggests.
This is storing up trouble. Investors are heading down into the darkened mine with no canary in the cage to warn of poisoned air.
So strong are their fundamentals that if there is to be a general deterioration in credit quality and rise in spreads for investment grade borrowers, this may take years, not just months to develop, unless the US and global economy should contract sharply.
But the testing time for leveraged credits might be closer to hand. Not only have LBOs been done at higher leverage ratios in recent months, many private equity investors, which used to rely entirely on capital gains for their income, have subsequently taken out early-stage dividends, so weakening these borrowers’ ability to repay.
New investors – hedge funds, specialist credit funds and CDO/CLO managers – in the riskier tranches of leveraged loans have risen to prominence in recent months. They are betting heavily on their skill at portfolio management, ability to deploy new-generation credit derivatives and looking as much to manage recovery rates as default rates. But they should remember that recovery rates tend to fall as default rates rise.
There are 337 rated single B by Standard & Poor’s. We’ll soon see just how good these new credit managers are.
