Investment grade credit – signs of late cycle?
Who’s been swimming without trunks?
After the worst start to the year from investment grade credit since 2008, many are wondering whether we are seeing cracks appear in credit markets.
A decade or so of extremely low interest rates and round after round of quantitative easing will have created excesses in the system. These excesses will be difficult to spot until prices start to reverse.
In keeping with the adage that we only see who has been swimming without their trunks when the tide goes out, rising US Treasury yields (Figure 1) represent the ebbing tide and certain corporate borrowers could prove to be the embarrassed swimmers.
Consumers in the US have spent much of the decade de-leveraging, many governments have been trying to, and banks are more or less unrecognisable from their pre-crisis guises.
However, non-financial companies have been piling on debt at the invitation of capital markets. A combination of strong earnings growth and high interest coverage ratios has kept the situation manageable, but quality in the sector has been declining.
In 2008, the investment grade credit index had some $700bn of BBB-rated debt. It’s now around $2.5trn – from under 40% of the sector to around half (Figure 2).
BBB issuance was 42% of total investment grade supply in 2017, a record for as far back as the data goes.
An asset not without risk
We remain wary of the investment grade credit market, but not because we see a raft of defaults coming from structurally challenged and over-leveraged sectors such as telecoms and retail. It is more associated with the meagre yield on offer from an asset class that is not without risk.
There is still a place for investment grade credit in portfolios, just as there is for government bonds; however, much like other areas of credit, as we enter the last phase of the economic cycle, extra due diligence should be rewarded.
Not all bad credits will be missed by the active management community, but for investors looking for a degree of safety with a slightly higher yield, it is important to be aware of the growing risks within the benchmark.