Two weeks ago, during the peak of the February market rout, UBS' credit strategist Matthew Mish looked at the latest round in the junk bond selloff and answered a rhetorical question: "
Is it time to buy" the bonds that comprise some/any/all of the bonds that make up the USD-denominated $3 trillion speculative grade universe. His answer was hardly pleasant for those who have kept peddling junk credit (including bonds, loans and revolvers) for the past several months:
- First, investors will require compensation for loss risks; cohorts of triple Cs typically experience 5yr cumulative default rates of 55 - 65% near the end of the cycle, implying half of the universe defaults before the end of year 5 and no longer pay coupons. Assuming recovery rates of 35% an investor should require roughly 12% yield to compensate for loss risks alone.
- What about mark-to-market and liquidity risks? While triple C bonds are trading on average in the low $60s, investors will likely need to stomach a further decline later in the cycle. Historically, triple C prices bottomed in the $40 – 50 range, so potential MTM declines could be significant.
And while the fundamentals' clear answer is "not yet", the one thing that concerned Mish the most is the ever rising illiquidity in the bond space, which is what prompted him to conclude that for junk yields have to hit as high as 25% before they become "attractive":
... investors will need to be compensated for the fact that illiquidity may prevent them from selling when needed. Bottom line, our conversations with investors suggest yields in the 20 – 25% context could be attractive enough to draw in marginal capital – although several investors noted that is reasonable for triple C risk excluding commodities. In short, we're not there yet.
In other words, "junk bonds" are actually... junk.
His bearish assessment led to a firestorm of protests from Wall Street asset managers for whom a selloff in itself had become a catalyst to buy: alas, the BTFD mentality so prevalent in equity markets over the past 7 years has spread to even the market's more rational corners. As such, someone telling them it's not a time to buy yet has led to a dramatic cognitive dissonance which demands an immediate explanation.
So, to clear up any confusion, here is Matthew Mish responding to the barrage of angry bulls why the $1 trillion in distressed credit - a third of the entire universe - is not just an energy story, and responding to the five most important and recurring questions:
- First, how do we get to $1tn in distressed credit?
- Second, what proportion is energy and metals/mining related?
- Third, where are we in the commodity default cycle?
- Fourth, when are the triggers for a refinancing crunch?
- Fifth, what is the scope of the problem outside USD denominated speculative grade markets?
Here is his full report:
$1tn in distressed credit: Not just an energy story
Our prior research on the fate of roughly one trillion in distressed credit has elicited a maelstrom of follow-up questions. Below we outline some of the most commonly asked questions to help frame out the size, scope and potential systemic risks posed by distressed corporate debt.
First, how do we get to $1tn in distressed credit? The traditional definition of distressed credit is the lowest-rated debt in the speculative grade bond and loan markets. In this context, we have previously shown that triple C rated debt currently comprises over 20% of US high yield bond market indices and 26% of all speculative grade rated issuers (bonds and loans, based on Moody's ratings and universe). Alternatively, the traditional market implied definition of distressed debt is debt trading at a spread greater than 1,000bp. Under this interpretation in the US HY bond market currently approximately 31% of debt outstanding is trading distressed. The comparable figures for US leveraged loans are smaller; however, they will climb through the credit cycle as rating downgrades and defaults rise. Our initial analysis focused solely on USD denominated speculative grade debt: roughly $1.5tn of US high yield bonds, $900bn of US leveraged loans, and $400-500bn of US leveraged revolving credit facilities and private debt securities. Simply put, 25 – 30% distressed within a broader USD denominated, speculative grade universe of nearly $3tn.
Second, what proportion is energy and metals/mining related? The bulk of commodity related debt was issued in the US HY bond, not loan market. As per above, the proportion of triple C rated HY bonds from commodity-related industries is 33%. Alternatively, the percent of commodity related distressed debt implied from market pricing (i.e., trading above 1,000bp in spread) is approximately 45% of the total. However, the proportion related to commodity exposure in the US leveraged loan market is lower. Based on our ratings-based and market implied approaches the proportion of commodity related distressed debt is 10-15% of the distressed loan universe. In sum, commodity related exposure is the largest single factor driving distress – but it is a minority share that, in aggregate, represents about 25% of all distressed exposure. Where are the other pressure points? The next largest sectors with distressed debt include: telecommunications, retail, healthcare, technology, media/entertainment and services.
Third, where are we in the commodity default cycle? The trailing 12-month default rate for the US speculative grade natural resource sector is 12.2%, up from 6.8% and 3%, 6 and 12-months prior; for context, 30 energy and 15 metals/mining firms defaulted in 2015 as per S&P. The forward outlook will depend heavily on commodity prices; however, even if prices stabilize and incrementally move higher (inline with the strip) we expect significant default realizations ahead. For HY energy issuers (excluding IG, crossover) liquidity options are running thin: debt capital markets are shut, banks are (attempting to) cut exposures ahead of the April redetermination and bondholders are tired of losing in distressed exchanges.
As per S&P there are approximately 100 and 50 energy and metals/mining issuers, respectively, in their speculative grade universe; based on market prices 85-90% of commodity related HY debt is trading at distressed levels (spreads north of 1,000bp), and 40-65% is trading in excess of 2,000bp. Bottom line, it is not unreasonable to assume another 50 – 75 defaults in the commodity universe over the next 12 months.Admittedly, credit spreads are leading commodity defaults; energy and metals/mining spreads are trading at 1,800bp – reflecting a high teens default environment. However, in a lower for longer world commodity spreads are unlikely to rally – spreads may tighten mechanically as a technical result of issuers defaulting and falling out of the indices. But we worry about the contagion effects to risk appetite and broader capital market access as investors roll through this default wave.
Fourth, when are the triggers for a refinancing crunch? In the commodity space, to be clear, bond maturities are not the trigger. Negative cash flow due to depressed profits is triggering bankruptcies (prepacks) as firms run out of liquidity; i.e., they cannot afford to pay interest – even as many do not face imminent maturities. The onus then is on the profit outlook for the broader speculative grade universe. We see profit declines persisting, partly as rising funding costs pressure fundamentals, but are not calling for a profit recession for the sector at this point. However, weak profits will coincide with rising refinancing needs in the next year to 18 months. In terms of maturities, the bulk of the nearer term wall is in loans, not bonds. According to S&P rated speculative grade bonds maturing 2016 – 2018 total $122bn, but loans (including pull-forward effects) maturing over the same period total $298bn (amid a backdrop of tighter regulation on bank lending and a plunge in CLO issuance3). The bulk of the maturing debt lies, first, in the telecom/ media/technology and, second, the energy/metals mining sectors.
Fifth, what is the scope of the problem outside USD denominated speculative grade markets? Our prior analysis does not incorporate two key segments of the global corporate debt universe: European and emerging market debt. On the former, the European high yield bond market is €325bn as per iBoxx, small in comparison to its US peer. And it is true that over two-thirds of the composition is higher-quality (double B). However, the lending model in Europe is bank loans, not bonds. According to the ECB Eurozone bank lending to Eurozone corporates is about €4.3tn, which includes high grade and leveraged loans (i.e., the comparable figure for European IG and HY bonds outstanding is €1.7tn). Disclosure on credit quality is lacking; however, based on syndicated loan issuance tracked by Dealogic we estimate roughly 20 – 25% of these loans are to leveraged corporates or nearly $1tn. Based on the sample of rated issuers roughly 25-30% (or €250 – 300bn) is lower rated and likely to be distressed credit through the cycle. Conversely, for the latter, the issue is further complicated by not only poor disclosure but also the interaction of corporate and sovereign credit worthiness.
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