Andrew Pyle
July 21, 2023
Cracks in credit
This week, we went to see the new Mission Impossible installment and, without giving the story away, it encapsulates probably the worst fears of people regarding the adoption of artificial intelligence or AI, which is pretty amazing considering the bulk of the content was assembled before the pandemic and well before this year’s AI craze. I’m sure that everyone thought about or discussed the potential areas where the movie might be close to reality. In particular, I wondered about how a malcontent AI might be able to infiltrate global trading algorithms to bring about outcomes that would be net beneficial. Perhaps boosting the value of a stock that would allow for increased capital financing towards investment in additional resources that support the AI.
The other week, I highlighted the strength of what are referred to as the “magnificent seven” and how these tech giants have dominated the U.S. stock market this year in both returns and weighting. If we go back to the end of last year, these companies had a combined market cap of about US$7 trillion, but this week that number comes in close to US$11.5 trillion – an increase of US$4.5 trillion. To put that number in perspective, it is larger than the annual nominal GDP of Japan in 2022 (the world’s third-largest economy). I’m not going to go through the analogies to the late-90s again, but based on where these stocks are trading, there is either going to be a realization of one of the largest earnings multiples in history, or this is going to end up as a mirage, might like the opening scenes from the movie. There are other less fantastical signs out there that are starting to make the hairs on the back of my neck stand up. These relate to risks emanating from the rise in borrowing costs across the economy and how they are starting to show up in credit.
Before getting into details, let’s step back and take a look at the landscape. Even though interest rates have risen dramatically over the past year, putting pressure on both households and businesses, the market appears to be in denial as to the impacts down the road. We don’t have to simply look at the gains in the stock market. Junk bond yields have fallen this week to the lowest levels since earlier in the year, and that takes the average spread to U.S. bond yields to just over 8.2%, which is the tightest we have seen since last June. This is still elevated in comparison with the summer of 2021, but that was a period of almost free money and insatiable risk appetite.
Today, money is certainly not cheap and lending conditions in the traditional market are tight. In other words, banks are less willing to take on corporate debt when there is a recession brewing. In the past, any restriction in credit availability would reverberate through the economy in relatively short order and that was when borrowing costs were lower than now. A good example of this is inventory management. Traditionally, companies finance their inventories with bank credit. If interest rates go up, there is pressure to reduce inventories as the cost of financing them goes up. Again, when rates were at generational lows, this wasn’t an issue. According to the latest National Federation of Business (NFIB) survey1 , the average interest rate on short-term loans paid by U.S. businesses is now just over 9%.
At the same time, there has been no discernible decline in total inventories. In the chart above, you can see that manufacturing and trade inventories just hit a new record high of US$2.545 trillion in May. The interest cost of supporting those inventories has vaulted and for those companies that do not have healthy balance sheets nor strong cashflows, this is going to compound the problem of upcoming maturing debt. The traditional avenue would be to whittle down inventories, however, in a weakening economic environment where demand is beginning to ebb, that means either discounting (implying even more compressed margins), or reining in production (implying lower output and employment).
Even if companies can support this level of inventories, the restrictive nature of traditional lending means that funding may not be available. Luckily (or perhaps not), another source of lending has taken off and that is private credit. Unlike banks, which need to adhere to stringent regulatory requirements, private credit funds can step in, not only to provide capital, but at rates typically higher than what traditional higher-risk loans would carry. And these sources are becoming increasingly available to retail investors, which raises another risk. Many of you still remember the financial crisis and how sub-prime loans and collateralized loan obligations (CLOs) contributed to a near-collapse in the global financial system.
This week, I saw two stories highlighting large U.S. financial institutions increasing their exposure to CLOs. Blackstone is acquiring the $3.6 billion CLO business from American International Group (AIG), making it the largest CLO manager in the market. At the same time, the company’s publicly traded “Blackstone Loan Financing Limited fund is looking to close it down given that the unit prices are trading at close to a discount of 25% relative to its net asset value. Blackstone has also become the first private equity firm to manage US$1 trillion, even though it experienced a 39% drop in distributed earnings in the latest quarter and a net reduction in inflows into its funds. The former leader in CLO management, Carlyle Group Inc, also announced that it is going to own 40% of a closed-end fund – Vertical Capital Income Fund – which is being renamed the Carlyle Credit Income Fund. This new version is going to move away from traditional residential mortgages to the highest risk tranches of CLOs.
On their own, these do not necessarily represent early-warning signs, and many will argue that there are other metrics that suggest credit quality isn’t deteriorating like some of the images in front of Ethan Hunt. Case in point, the charge-off rate for commercial bank loans and leases (reported by the Federal Reserve quarterly 2) was only 0.4% as of the first quarter. This rate is the percentage of loans and leases that are in default as a percentage of total loans and leases outstanding. That is below the peak after the pandemic, but still double where it was at the end of 2021. At the peak following the financial crisis, this rate was at 3%.
That said, the trend is not heartening. So far this year, more than 40 companies in the U.S. have defaulted – more than double the number during the same period in 2022. According to Moody’s Investor Service, defaults are forecast to increase in the highest-risk segment of the corporate debt spectrum and they see defaults reaching 4.6% by the end of the year (compared to a 4.1% long-term average). These estimates are largely in line with other rating agencies and analysts.
Another potential sign that the market is either not adequately pricing in credit risk and/or recession risk was in full sight this week when Carvana (the U.S. used-car company) reported earnings for the recent quarter that was ahead of expectations, but also announced that it was going to restructure a piece of its massive debt load. The amount in question was about US$1.2 billion and knocks out more than 80% of the issues that are maturing in 2025 and 2027. Those bonds that come due have coupons in the 5.5% area – something that the company wouldn’t be able to get if it issued today – hence the need for restructuring.
At its intraday high on Wednesday, Carvana’s stock price had jumped above US$50, making for a 1,390% increase since the start of the year. Before we get excited though, this is still 85% below its 2021 peak above US$350. By Thursday, some reality had kicked in with a couple of firms downgrading their price estimates. The bottom line though is that Carvana is just the tip of the iceberg of high-yield companies that managed to issue debt at not only very tight spreads, but lower all-in coupons than were not justified by fundamentals.
While we watched these developments this week, we also heard more and more analysts come out and either lower their probabilities for a recession or took the recession off the table completely. Market volatility was also flirting with the lows of the year and this combination also tends to get my neck hairs up. This is why our strategy is to stick with a solid portfolio consisting of investment-grade corporate and government bonds, while minimizing loan exposure and having next to no high-yield. At the same time, we are maintaining a decent buffer of cash in case of an equity market pullback, where valuations will be more attractive on the other side.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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