Tuesday 20 October 2015

Credit - Liebig's law of the minimum

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed." - Mahatma Gandhi

Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through, but, when it comes to our chosen analogy, we decided this week to leave out the "explosive" references and steer towards a principle developed in agricultural science by Carl Sprengel (1828) and later popularized by Justus von Liebig.  The Liebig's law of the minimum states that growth is controlled not by the total amount of resources available, but by the scarcest resource (limiting factor). For us, this important factor is "capital", particularly in the light of ZIRP and repetitive QEs hence this week's title analogy. 

Liebig's law of the minimum concept was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Only by increasing the amount of the limiting nutrient (the one most scarce in relation to "need") was the growth of a plant or crop improved (preventing mis-allocation of "capital"). This principle can be summed up in the aphorism, "The availability of the most abundant nutrient in the soil is only as good as the availability of the least abundant nutrient in the soil." Or, to put it more plainly, "A chain is only as strong as its weakest link."

In similar fashion, if we take biotechnology itself being totally dependent on external sources of natural capital, capitalism and CAPEX expenditures also depend on efficient market allocation of "capital". Obviously QEs and ZIRP, to that extent do not help whatsoever the process, on the contrary the distortions have been immense hence our Liebig's law of minimum analogy.

Also when it comes to our analogy and the "law of a minimum", we think investors should more and more focus on the return of "capital" as a "minimum" rather than focusing on the return of "capital" as a "maximum". Yes, there has been a strong rebound in inflows in recent weeks particularly in High Yield ETFs, but, looking at our much discussed "CCC credit canary" bucket and the dip in new issuance for the latter, it is a harbinger of trouble ahead we think, hence our recent call for moving higher in the ratings spectrum. If we would like to tweak slightly the previous aphorism we would state the following: "The credit cycle is only as strong as its weakest link, namely the CCC credit canary". 

While there has been a positive momentum in credit and equities alike, leading to strong inflows, with "bad news" on the macro side with weaker China GDP growth, leading to somewhat "good news", at least on the credit side, we think that financial system vulnerabilities have risen, thanks to the commodity down cycle in conjunction with the sharp depreciation of currencies in Emerging Markets (EM), particularly for commodity exporters such as Brazil. These developments have clear implications for foreign-denominated debt particularly for the corporate ones as discussed recently. There is a heightened risk for EM and DM banking systems alike for significant loan defaults and banking system losses in 2016.

In this week's conversation, we will look again at the consequences positive correlations have had on idiosyncratic risks and why in the current tightening mood, you should this time around avoid getting "carried away", meaning stretching for yield and risk given the lateness in the credit cycle.


  • Positive correlations means idiosyncratic risks are rising
  • More on the credit cycle turning - don't get "carried away"
  • Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

  • Positive correlations means idiosyncratic risks are rising
While in August we voiced our growing concerns on the rise in positive correlations and the instability it was generating in our short conversation "Positive correlations and large Standard Deviation moves", the recent significant price movements we have witnessed on numerous occasions, indicates clearly to us that this instability is leading to sudden bursts of volatility and large standard deviations move. We would not call that a "new normal" environment but, we think it is akin to the "law of minimum" in a ZIRP central banks induced world. 

This rise in idiosyncratic risks has been confirmed by Bank of America Merrill Lynch in their latest Credit Derivatives Strategist note from the 14th of October entitled "Refocusing on the big picture":
"The rise of idiosyncratic risksThe EM driven volatility is here to stay. Names with significant sales exposure to EM have borne the brunt during the recent sell-off. Additionally the consequent commodity price sell-off has triggered an increasing pressure on metals and miners. But on top of the global growth headwinds, we have also seen a significant rise of pure idiosyncratic risk recently both in high-grade and high-yield market. Multiple single name stories have been popping around. The VW story is casting a shadow on the autos and auto parts sector. Abengoa has also been on the fore over the past couple of months. Matalan recently saw their bonds down ~10pts.
Our Plunging bonds index is reflecting exactly that; the rise of idiosyncratic risks. Note that the number of bonds that dropped more than 10pts in a month spiked to the highest level in September.
However, the performance in the month of September was not that catastrophic across the board. After all not many European companies are either exposed to EM or have been affected by the VW story.
A way to illustrate the diverging performance across high-grade cash sectors is by tracking the standard deviation of their excess returns. In chart 3 we present the standard deviation of monthly excess returns for a number of non-financial sectors over time.

We find that the level of dispersion in September has been the highest since the 2008/09 global financial crisis, and far worse than the one experienced during the European sovereign crisis in H2-2011.

Note that while autos and industrials were the ones that dropped by c.4%, the rest of the market was down by ~1% on average (chart 4). These two sectors represent only ~10% of the entire high-grade market.

Record low financing costs…default risks should be contained…Default rates have historically been highly correlated to companies’ financing costs. We find that the loan interest rate cost is a good leading indicator of default rates (in the following 12 months, chart 5). 

With the ECB likely to expand/extend QE beyond September 2016, financing costs are likely to remain low for longer. Should this trend continue the currently low financing costs should support low default rates suppressing systematic default risks. 
The recent EM-driven weakness has driven spreads significantly wider, decoupling from lower loan rate costs for European companies (chart 6).

This provides more attractive levels to selectively add risk in credit instruments that have a cushion to first losses. 
Fundamentals improving…no re-leveraging despite enticing financing rates
Inflation and financing costs have been ticking down over the past couple of years. Corporate fundamentals are clearly improving. Over the past six quarters, leverage has fallen due to an improvement not only in earnings, but also thanks to lower debt overhang. Chart 7 shows that European corporates have not embraced more leverage (more in our dedicated HY fundamentals note), despite enticing record low financing costs."
- source Bank of America Merrill Lynch
We agree with Bank of America's take when it comes to European valuation being relatively more attractive compared to the US thanks to lower overall "leverage". This what we argued in our conversation "The overconfidence effect", US "releveraging" has been fast and furious which is not yet the case in European credit (far less "leverage" and "buybacks").

But, we cannot agree with Bank America Merrill Lynch's use of loan interest rate cost as a good leading indicator of default rates. This is misleading we think in this credit cycle. This time, it's different!

Why so?

In September 2014 in our short note "US High Yield issuance and debt outstanding" we indicated the following:
"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far.
Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans"

- source Macronomics, September 2014, graph Morgan Stanley, March 2013.
Europe is an on-going story of "deleveraging" when it comes to its banking sector. Banks are not making that many new loans, particularly in peripheral countries because weaker banks are still capital constrained! If you think banks have completed their deleveraging, then watch German banks and in particular Deutsche Bank. More pain to come, more assets to be offloaded, more jobs to be cut.

Using again our Liebig's law of the minimum analogy, the limiting nutrient (the one most scarce in relation to "need") for European banks is "capital". 

As a reminder credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and their "core capital " has been artificially boosted by Deferred Tax Assets (DTAs). DTAs are like "Aspartame", an artificial, non-saccharide sweetener used as a sugar substitute in some foods and beverages but, when it comes to European banks by no means it can be considered true "capital". DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios. This is significant!

With loans you have covenants as an alert system, even less so in the US with the return of Cov-Lite loans,  and with bonds, not that much covenants, hence the significant increase in "idiosyncratic risk".

Furthermore, we agree with our Rcube friends recent take on "bonds" being now a more serious indicators than "loans":
"We have been highlighting for months now that the combination of redemption and rising cash levels would be equal to a serious tightening of bank’s lending standards. This is because the share of corporate financing now achieved through capital markets has massively increased over the last 10 years. Bond funds have taken over loan officers as the main credit providers to corporations around the world. Only watching banks’ lending standards to evaluate the health of credit flows is a serious mistake in this cycle. In the US alone, the ratio of bond issuance vs. loans is 5 to 1. For risky assets to drop, negative sentiment is a prerequisite condition. It is now the case." - source Rcube

While we might be sounding like a broken record but, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger, even for European Issuers, regardless of their EM exposure, or not.

This brings us to our second point namely that in a context of deteriorating "credit metrics" for High Yield issuers (and no it isn't only bound to the "Energy" sector...), we think that investors should focus on return of "capital" rather than return on "capital" because  increasing amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth) so far, although we keep hearing from the "snake-oil" pundits that's the "recovery" is just around the corner:

US Labor force: For the first time since May 1990 the Ratio Not in Labor Force / Civilian Labor Force has topped 60%:
- source Macronomics

  • More on the credit cycle turning - don't get "carried away"
Whereas cheap credit has enabled some "extend" and "pretend" game, one of the major consequences has been to allow the extension of the "Maturity wall" to a later stage as illustrated by Bank of America Merrill Lynch in the below graph displaying the maturity profile for US High Yield bonds and Leveraged Loans:
- source Bank of America Merrill Lynch

In similar fashion, for some distress issuers in Europe, the game has been extended to "overtime" but in no way has altered the necessity for some form of "restructuring" as illustrated recently by the situation of Norske Skogindustrier ASA, a Norwegian pulp and paper company based in Oslo as reported by DataGrapple on the 16th of October:

"So NSINO (Norske Skogindustrier ASA) eventually paid their 2015 bonds. The company has apparently decided to buy some time in order to find a suitable solution to manage their considerable debt pile. Their next maturity falls in May 2016, but once these junior bonds will have been paid, there will be very little cash to redeem other maturities. It is therefore no surprise that holders of longer dated bonds are mulling restructuring plans. A group of investors holding NSINO’s 290mln euros of senior bonds due 2019 allegedly met with the company to discuss a possible debt for equity swap. Holders of junior bonds due 2017 approached management with an alternative plan that included extending their claims until after 2019. The company is conveniently in blackout period ahead of its results on October 22nd. They should expect a grilling then regarding their intentions. But in the meantime, as their willingness to kick the can down the road was evidenced by the payment made yesterday, investors have steepened the risk premium curve of NSINO on the short end. The 1 year CDS closed today at 29pts upfront, 10pts lower than 2 days ago." - source DataGrapple
Of course, in similar fashion, the "lunatics" running the "central bank" asylums have also played the "buying some time" game to say the least. They seem to be oblivious to Liebig's law of the minimum but we are ranting again.

We think it is high time investors start thinking about "playing" defense", this means going higher into the "ratings" spectrum. As goes our second point, do not get "carried" away, meaning stop "selling "beta" for "alpha" (though we do know that the first source of "alpha" are fees to quote one of our Hedge Fund manager friend...) because the cycle is running out of steam. 

On that note, we could not agree more with Bank of America Merrill Lynch's High Yield Wire note  from the 19th of October entitled "Fool me once, shame on you, fool me twice…":
"All credit cycles come to an end. This one’s no different.We’ve said for a while now that the benefits of low rates have long been sapped from the market, and we are in no rush to change our tune on the back of a two week rally. As we look at the fundamentals of the market, our strategic view on high yield remains crystal clear: the market is in its 7th or 8th inning and still needs to cheapen substantially before valuations become attractive. With the risk for 100s of billions of investment grade downgrades, our view that defaults will soon be increasing, and that Fed stimulus is no longer a tailwind to the market, our expectations are for wider spreads in 2016. This is not to say we expect a massive default wave next year, but do wonder whether the lack of liquidity and general direction of the market creates an attractive entry point anytime soon. 
Spread compensation not enough for what matters: ReturnsAs we have been traveling across the US and Europe the last 6 weeks we have heard two arguments why investors may find value in high yield. First, there is a lack of alternatives. Second, with the recent widening, spread compensates you for the default expectations priced into the market. We don’t agree with either. Investors need to demand return, not yield. A 7% coupon does not yield a 7% return and with the potential for low average returns for some time, we think alternatives do in fact exist. Additionally, traditional measures of spread compensation are flawed in our view, and need to be seen in the context of alternatives and default risk over the life of a portfolio." - source Bank of America Merrill Lynch

When it comes to Liebig's law of the minimum and "return" of capital, we also agree with Bank of America Merrill Lynch's take on the need for looking for "quality" rather than yield:
" All credit cycles come to an end. This one’s no different.
Over the last couple of years, the market has frequently been fooled by assuming a new old world where bad news is bad news and good news is good news, only to be whipsawed by risk on sentiment where fundamentals matter less than easy monetary policy. At the risk of being fooled again, we say the tide has turned, and low rates and pushed out hike expectations matter less in a world where sentiment has shifted, fundamentals are poor, and investors are not being compensated for default and
liquidity risk.
It is interesting how so few disagree with us that fundamental metrics in HY are quite poor and unlikely to take a turn for the better any time soon and yet so few agree with our thesis that this is highly problematic. The effectiveness of central bank policy in boosting asset prices over the last few years has created a blind spot when it comes to fundamentals. This is apparent when the only counter to our argument is “where else will the money go?”
The steadfast belief that low rates and the central bank put will continue to mean a reach for yield, never mind it’s quality, seems absurd and contrary to evidence. It’s been six years since the recession; we’ve had numerous rate cuts and quantitative easing programs the world over, we’ve seen all-time high stock prices and we’ve witnessed all-time low bond yields, and yet neither the market, nor it seems the economy is allowing the Fed to hike rates. As Thanos wrote recently, we should have known something was wrong when bad news was greeted more cheerfully than good news.
Ok, so what has changed now you say; if central banks continue to remain so accommodative, why not more of the same? Because the last six years have also borne witness to the fastest growth in corporate debt that we’ve ever seen and re-leveraging to a scale comparable to the worst moments in HY’s history.  
This has occurred in conjunction with mediocre revenue growth, disappointing capex spending and earnings burnished by buybacks and acquisitions. And just as credit quality started a turn for the worse, risk aversion has set in quite firmly within the market. The flight from Energy and the reluctance to step back in even at today’s highly distressed levels amongst investors has been stark, as they anticipate many HY E&Ps to raise priority debt ahead of existing bondholders and potentially file for bankruptcy. Even the erstwhile “safer” places to hide may not make the cut going forward. We have already seen some unraveling in the traditionally defensive pharma market with stock and bond prices of drug makers taking sizable hits on the prospects of drug price caps. Lately, the risk aversion has spread to mainstream hospitals too- case in point HCA equity down 23% since August 4th.
In the same vein BBs, which have outperformed Bs and CCCs all year (BBs -0.93%, Bs -2.67%, CCC -7.14% YTD), face headwinds from falling angels once rating agencies begin downgrades ahead of the default cycle. In the past two migration cycles, an average of 10% of the starting IG universe was downgraded to HY over the course of the cycle (Chart 3). 
This translates to as much as $300bn worth of par value in cumulative downgrades over the next 3 years if the rating agencies begin to shift their expectations in 2016. Should history repeat itself, these downgrades will expand the current BB universe by a whopping 63% and the overall size of the high yield index by nearly 25%.
Of course, existing BBs today will also suffer attrition by way of downgrades to Bs, and Bs to CCCs, but the overall indigestion to the market could prove massive. We hear so much about the potential for outflows, but very little about the potential for new paper through downgrades. The latter dwarfs the former.
Finally, the re-pricing in the primary market as issuers bow to investor demands is just another reminder of waning risk appetite. Never before has access for CCC issuers, even non-commodity ones, been so poor post crisis. The proportion of low quality issuers accessing the market on an annual basis has now dipped below 20%, a far cry from the 50% at the top of the cycle. It doesn’t take much to see what this means for the survivability of low quality issuers going forward. In fact the previous times we were at these levels and heading in the wrong direction was in 1989, 1999, and 2008, right at the heels of default waves (Chart 5). 

Of particular interest is that once CCC issuance (as a percentage of all existing triple C issuers) falls below 20%, the default rate tends to spike north of 10% within a year and a half on average. In the late 1980s/early 1990s, the time to double digit defaults was 20 months, in the late 1990s/early 2000s it was 22 months and in 2008 and 2009, it was just 14 months. Assuming a similar pattern today, one would expect the current risk aversion to lead to a significant pickup in defaults sometime in mid-late 2017, consistent with our previously published estimates. 
The idea that once again bad news is good news and good news is bad news has no merit in our view, especially in the context of all the late stage indicators we are seeing. We’ve said for a while now that the benefits of low rates have long been sapped from the market, and are in no rush to change our tune on the back of a two week rally. In fact, we would argue that we have witnessed nothing but a dead-cat-bounce in HY, and a price action which has little if anything to do with the expectation for rates or improved fundamentals, and everything to do with ETF buying and short covering. The $2bn+ that flowed into ETFs in the week ended Oct 9th was the highest on record for HY ETFs (Chart 6). 

This was the same period over which the HY index staged a dramatic 70bps of spread tightening, but has since given back some gains. In contrast, actively managed retail funds saw a meagre inflow of $140mn over the same period.
Note that the market was pricing an impossibly low probability for a hike before September’s meeting and that the market sold off all summer despite treasury yields falling. In fact, after Yellen’s press conference, where she discussed the lack of inflation and weak global growth as the main reasons for keeping zero interest rate policy, the market sold-off. Yet, we are meant to believe that when the same concerns were expressed in the minutes, everyone had changed their mind that these issues were now a good thing? We don’t buy it.
As hard as it is to accept that this glorious run for credit has come to an end, in our view it is time to acknowledge that valuations do not justify the risk-reward profile in HY, and no amount of QE or easy monetary policy is likely to change the story for an extended period of time. The market is in its 7th or 8th inning and without a substantial increase in earnings- a prospect that will require fiscal policy changes more than monetary stimulus, in our opinion- we think high yield will have a difficult time sustaining rallies. And to substantiate that view, we attempt to counter the most frequent arguments we’ve heard from those who disagree. 
Spread compensation not enough for what matters: ReturnsYield does not equal returnThis may be stating the obvious. But we find it necessary to say so anyway. The most vociferous argument for HY seems to rest on the fact that it indeed provides a high yield; more importantly a higher yield than Treasuries, high grade and perhaps even expected stock returns. But what good is a high coupon if enough price loss and defaults occur to wipe away any cash inflow? We would think investors would search for return, not yield, in which case, in our view compensation is not commensurate with the alternatives.
In late December last year, the yield on our HY index was over 7%, the highest it had been in over two and a half years. Just a few weeks back it was over 8% and year-todate returns stand at -0.6%. High yield or higher yield than recently observed did not by themselves preclude an even higher yield or negative returns. Why opt for 2-3% returns in HY with its volatility, defaults and liquidity challenges when HG paper yields 3.3%, has less volatility and virtually non-existent default risk?" - source Bank of America Merrill Lynch
Given the "holding" pattern of the Fed, we believe as well, that US Investment Grade has become somewhat attractive again. On that matter of "quality", we have read with interest Bank of America Merrill Lynch's Situation Room note from the 20th of October entitled "It’s what you don’t see that hurts you":
"Cash gets no credit
High quality industrial spreads are attractive relative to their lower quality HG counterparts. This is because currently single-A and BBB-rated industrials offer similar spread levels per turn of gross leverage (ex. energy, materials, utilities) – see Figure 1. 
This means that investors give A-rated industrials little credit for their superior liquidity positions, with higher quality industrials holding about twice as much cash on their balance sheets as BBBs (Figure 2). 

In other words, current valuations assign close to zero value to the much lower net leverage of high-quality companies compared to their lower rated peers. With corporate releveraging expected to slow we think credit market valuations should become more aligned with net than gross leverage. While a significant portion of corporate cash could be overseas, it would still be available and useful to repatriate - after a tax haircut - in situations of distress. 
The trend in gross leverage for both high quality and BBB-rated industrials has been similar, with the median leverage rising since 2012 (Figure 3). 
In contrast the higher cash balances actually pushed the net leverage down for single-A rated issuers, while net leverage increased for BBBs (Figure 4). 

In fact, about 40% of single-A issuer in our credit universe (ex. energy, materials, utilities) have negative net debt as of 2Q-2015." - source Bank of America Merrill Lynch
"Quality" indeed in Investment Grade credit is once more a "compelling" argument, we think, given the lateness in the "credit cycle".

While in September we would confide we have been adding on our US long duration exposure, it seems to us that in a "deflationary" enclined world, "quality" credit Investment Grade is still good value for your money, US High Yield doesn't appear to us like it and this bring us to the main reason we have also discussed in recent weeks is the rise in the cost of capital and global tightening financial conditions (think about our CCC Credit Canary and its issuance "issues"...).

This brings us to the final "inning" of this week's credit conversation, namely that in Liebig's law of the minimum, what matters in a D for Deflationary world more and more is the return of your capital, not the return on capital.

  • Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 
While we recently boasted on the attractiveness of "deflation floors" for US Tips as compelling in a "D" world, there has been as well as of late, some evidence of the rise in the cost of capital hence a slowdown in buybacks and US corporates starting to become more defensive of their "balance sheet". We would like to point out David Goldman's comments which can be found on Reorient Group's website from their note from the 18th of October: 
"Part of the reason for lower per-share profits is the decline in equity buybacks. Factset reports, “Companies in the S&P 500 spent US$134.4 bn on share buybacks during the second quarter. This represented a 6.9% decline in spending from the first quarter. At the sector level, six out of eight sectors saw a sequential (quarter-over-quarter) decrease in share buybacks at the end of Q2 (excluding the Telecom and Utilities sectors, which have each averaged less than US$2 b in quarterly buybacks since 2005).” 
Buybacks, in turn, have declined because the cost of financing them has risen. The spread to Treasuries paid by medium-grade corporate borrowers rated Baa/BBB has risen by a full percentage point since July 2014.

In a zero-inflation and borderline deflationary environment, 5.4% interest on term debt is real money, and corporates are getting reluctant to lever their balance sheets in order to show higher per-share earnings. During the past five years, the 100 members of the S&P 500 with the highest proportion of share buybacks (the S&P 500 Buyback Index) outperformed the rest of the index by 20%.
Source: Bloomberg
During the July-September correction, though, the S&P Buyback Index underperformed, losing 4% against 1% for the S&P as a whole.
That’s an important signal that the quality of the carried asset ultimately is more important than the cost of carry. If earnings continue to deteriorate, carry trades will start to resemble the conclusion of the Stephen King film with the homophonous name. " - source Reorient Group - David Goldman - 1§th of October
While it isn't yet "Nightmare" on "Credit Street", it looks to us that while leverage matters, earnings matter even more when it comes to "default" risk as we posited back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, at the time we argued the following:
"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012

One thing for sure, don't get "carried" away, preserving "capital" sure is the law of the minimum...

"Words have no power to impress the mind without the exquisite horror of their reality." - Edgar Allan Poe

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