By Hamlin Lovell, NordicInvestor
In the first two months of 2019, credit markets have staged a sharp recovery, partly based on expectations that the Fed may pause on rate rises, and hopes that the trade war could be resolved – or at least not escalate further. But Thorp is: “nervous over the speed with which markets have rallied back. A continued economic slowdown could leave central banks with limited firepower and the economic outlook is moderate at best. There is much paper to refinance in the near term (approximately $5.5trn over the next 4yrs) which will likely require higher spreads and yields”.
He is, “rather cautious on credit markets. The iTraxx crossover – broadly a BB rated credit index – could widen out to from 275 to 350 or 400 basis points, which would imply high yield spreads increasing by 100 to 150 wider”. Given how low yields are, this scenario would make it difficult for credit indices to post positive returns especially given the recent rally in markets.
Both fundamentals and technicals matter in credit markets. For instance, fundamentally, US loans arguably underperformed European loans because the Fed was raising rates while the ECB was not. Leveraged loans are perceived to be fundamentally relatively safe because they are senior in the capital structure, but technical factors weighed on the segment last year: “excess money had poured into CLO warehousing, and there more leverage is applied to loans than high yield bonds, so the animal spirits instincts of greed and fear can become more relevant” says Thorp.
As well as leverage in some areas he is, “concerned about liquidity and price gap risk in credit markets, as the corporate bond market has grown enormously but banks hold much less inventory”.
China and Brexit
Thorp is “finding the best opportunities in Germany, which is oversold on poor economic news, being directly impacted by the slowdown in China, and US/China trade talks. But some of the weakness is due to one-off events that should right themselves this year, such as the drought and low levels of the Rhine”. Though the snap back in European credit has retraced the whole of the November/December downdraft for some names, others have only recovered perhaps a third in spread terms. “There are stressed names trading in the 50s, 60s or 70s that have been sold off on general market disruption and might bounce back” he says.
Brexit fears have also contributed to volatility in some European names that rely heavily on the UK, as well as some UK names, and Thorp has spotted some oversold situations – though in February they have often been bid up again, as fears of a hard Brexit recede.
Geographically, he sees scope for emerging markets to outperform developed markets, but would pick regions carefully: for instance, “broadly we like what is going on in Latin America, which has had a decent rally in Brazil” he says.
Thorp opportunistically invests in Asian credit but pays more attention to it as a barometer of conditions in China. “The major segment is Chinese property. If that remains robust, generally Asia and China should be well contained. If there is spread-widening, we would also start to get cautious on non-financial credit”.
He is cautious on Australia on account of its exposure to China’s slowing economy. A hard landing in China and/or a US recession could see corporate default rates spike to as high as 10%, he reckons.
Defaults and shorts
But irrespective of the economic backdrop, Thorp expects corporate defaults will increase towards 4-5% because some companies face secular decline amid new technology and other challenges such as disruptive business models of rivals. He is also of the opinion that default rates would already be higher if covenants were much tighter.
Defaults apart, plenty of names are gapping down ten points after reporting disappointing results, while there are limited bids for those trading between 60 to 85 cents on the dollar. Thorp envisages some of these companies will eventually require restructuring.
In terms of credit ratings, he views the ballooning BBB-rated category as vulnerable, as the volume of debt in the group has grown massively as a proportion of the investment grade universe – and these firms are only a notch or two above speculative grade. A possible catalyst for ratings downgrades could be new accounting rules that shift some forms of off-balance sheet debt onto balance sheets, which if corresponding earnings are not applied, could increase some investment grade firms’ reported leverage metrics to levels more typically associated with speculative grade issuers. In fact, “a number of names with BBB ratings currently have worse credit profiles and financial ratios than those with BB or B ratings, and as ever, the credit ratings agencies are behind the curve, which creates opportunities for managers on the short side” he says. Thorp has observed names dropping seven to 10 points upon downgrades.
But the arithmetic of shorting means that timing is of the essence: “if the coupon is 4% and short borrow costs add up to 2%, then it costs half a percent a month to be short – and there is no profit if the bond goes from 100 to 94 over a year” he points out.
Thorp is identifying short ideas in some sectors, such as semiconductors, and autos exposed to diesel or China, that have clear headwinds – but every industrial sector has weaker members that could be short candidates.
Aggressive accounting and fraud are not big themes at present, but Thorp is always mindful of anything “off piste. Credit investing should be safe and boring and we should understand how a business generates free cash flow. We prefer countries where judicial systems protect bondholders and avoid structures where money can be moved away from creditors”.
Thorp is also looking at relative value trades, including pair trades, basis trades and capital structure arbitrage trades such as credit versus convertibles, or sometimes equity against convertibles.
Overall, “it is a much more interesting market than a year or 18 months ago. Quantitative analysis for screening and valuation, combined with bottom-up fundamental research, are identifying interesting opportunities” he says.
In terms of macro, “the world is in a very interesting situation with increased geopolitical risk and more uncertainty over economic solutions. If the world slows again, I would expect a different policy mix, not simply one-dimensional buying of debt to reduce volatility and move credit valuations to uninteresting levels”.
The outlook should bode well for active credit managers with the flexibility to pursue long, short and relative value trades.