....high stock prices don't help themselves because it would lead the Fed to keep rates higher for longer as inflation stands to perk up again. And higher for longer rates would at some point lead to a tipping point for a credit market distress that is yet to show up.
....this is why I said the action(s) of a few can negatively impact the fate of the many. It is only a few that enjoyed the big gains, .....the many small businesses that Lance Roberts mentioned are not feeling the economy is helping them. And many small and micro cap stocks are not doing a Lazarus despite the all time highs. Grand predictions of credit market distress confound the bears
The corporate debt markets are just as jubilant as sharemarkets. But will it stay that way if interest rates remain high? Jonathan ShapiroSenior reporter
Feb 25, 2024 – 8.52am
While sharemarket investors are debating whether we’re in a bubble or a bull market, there’s more than a whiff of exuberance in the supposedly discerning credit markets.
On Thursday, Macquarie Bank, which ranks well below the big four in the credit pecking order, raised $1.25 billion of subordinated bonds at the same rate as larger rivals, while setting a record for the size of the order book.
Meanwhile, in the securitisation markets, debut borrower Orde Financial raised a cool $1 billion, and local and foreign lenders are courting the non-banks with new lines of credit.
The riskier portions of deals that brokers couldn’t give away a year ago are now more than eight times oversubscribed as the task of putting money to work becomes a mad scramble for yield.
Seasoned bankers and bond investors have seen much wilder stuff in the past 20 years. But even they have been taken aback by the love and liquidity out there.
The bullishness of the equity market is all pervasive. And just as equity investors are trying to calibrate the bull market enthusiasm with the interest rate and earnings outlook, so too are corporate debt investors.
With hundreds of billions of dollars gushing into the credit market, lured by high returns and security, the concern is whether the fundamentals may ruin everything. Will those higher payments strain borrowers and trigger defaults and losses?
“Despite so many economists and fixed income managers screaming ‘recession’, the credit margins reflected in the market are so tight they are saying they are wrong,” says Renny Ellis of fixed income manager Arculus Funds Management. Borrowers are coping
So far, to everyone’s astonishment, those defaults are largely absent. Whether it’s highly indebted Australian households or geared-up American corporations, borrowers are, in aggregate, coping with higher interest rates.
The big four banks have all fronted the market in the past fortnight and reported modest increases in arrears but well below what anyone had feared.
Is the wave of defaults just on the other side of the horizon? This week, we attended several fixed income fund manager pitches; they are all confident we won’t experience a material rise in defaults, with one exception.
US fund manager Invesco is one of the largest investors in leveraged loans, which are typically used by private equity to finance buyouts. The borrowers by definition are geared up while the interest payments are floating rate. So the jump in US interest rates has doubled their lending rate to more than 10 per cent from about 5 per cent.
But portfolio manager Gerard Fogarty told this week’s Portfolio Construction Forum that borrowers are coping better than even he expected.
In 2022, the fund tested its exposures for a rise in interest rates and a 10 per cent fall in earnings. This would cut the interest cover ratio (the extent to which earnings cover interest payments) to 2.1 times from 4 times.
But corporate revenue and earnings, he says, have grown consistently for the past eight years which means that ratio is at 3 times – well above the 1.5 times considered stressed.
The defaults are coming, though. While private equity-owned companies can meet their interest payments, refinancing debt on maturity will prove challenging and may require an injection of capital or default.
However, Fogarty says high interest rates and recovery rates more than compensate for that risk. Billions in bad loans
In the US junk – or high-yield – market, investors say the quality has improved significantly. The pandemic broke the weaker borrowers while some investment-grade companies slipped into junk territory, improving the mix. Since this market is fixed rate, most borrowers have locked in low interest costs.
But Bank of America research, quoted by Dan Loeb in his investor update, finds that about 40 per cent of all borrowers with B or CCC ratings – about half the market – will have negative free cash flows once they refinance at market rates.
Even though default rates are low, the growth in corporate debt markets means that in absolute terms, there are tens of billions of dollars of bad loans out there.
The size of the US distressed universe (measured by bonds trading at a 10 per cent spread above the risk-free rate, or loans trading below 80¢ in the dollar) is about $US150 billion ($229 billion).
This is what distressed debt funds feed on, and over time, they’ve tended to generate strong returns.
Duncan Farley, who helps oversee a special situations fund for BlueBay, a London-based $111 billion fixed income manager, toured Australia to meet prospective investors last week.
The strategy has delivered double-digit returns for the past four years by investing mainly in stressed and distressed bank loans and bonds at a time when defaults are modest.
He argues that the sharp rise in funding costs will inevitably catch up to some companies, whether it’s now or in three years’ time.
“We’re not going to have a GFC moment where you have a spike in defaults and if you blink you miss it,” he says. Instead, he expects several years of elevated default levels as stressed borrowers suffocate rather than blow up.
Distressed debt investing is not without risk. Some of the world’s largest distressed debt funds snapped up bonds of failed Chinese property developer Evergrande. The bonds traded at about 3¢ in the dollar before tripling to 10¢, but it seems they’ll lose everything as near nil recoveries are expected.
In fact, the recovery rate on US loans has fallen to an all-time low of 38¢ in the dollar.
In Australia, there are pockets of stress in the corporate sector, such as in healthcare, which is more discretionary than previously assumed.
One sector that had some lenders anxious is housing construction as the sharp rise in building costs forced many developers into bankruptcy.
Higher house prices and low defaults is not what anyone had on their bingo card when interest rates topped 4 per cent.
But lenders in this space are as upbeat as ever. Mark Power, of $8 billion specialist property lender Qualitas, told the Portfolio Construction Forum it has no troubled loans across a large portfolio.
He says there is anecdotal evidence of problems at other lenders, most likely the result of lending to undercapitalised developers.
The reason Qualitas is so confident it will be able to lend money at attractive interest rates with limited losses is because of the chronic shortage of housing relative to population growth.
Vacancy rates of 0.8 per cent are well below the 3 per cent equilibrium rate. The fund estimates that 143,000 apartments need to be built in Sydney, Melbourne and Brisbane to keep up with demand. Only 65,000 are forecast to be built.
Power candidly says this chronic shortage is tough for society but will be a source of attractive returns for financiers of the projects that get off the ground. Lenders have been earning double-digit returns.
Asked whether investors are better off investing in property debt than in equity, Power agrees this has been the case, but since apartment prices are appreciating again, so too are the spoils to equity investors in development projects.
Higher house prices and low defaults is not what anyone had on their bingo card when interest rates topped 4 per cent. Have we been lulled into a false sense of security?
It may mean that base rates have to go higher to slow demand enough to bring inflation to target. Or companies might find they can’t increase prices and will have to cut costs, including staff, leading to higher unemployment and mortgage stress.
For now, credit markets are bouncing, which is welcome news for any individual or business with a refinancing task. But as those who have seen a few cycles know, the taps can be turned off with little notice.
