Graphic Content – August; Lower HY issuance masks growing US corporate sector liabilities
14th August 2018
Credit spreads in US high yield have performed better than US investment grade this year. Since the start of the year, spreads on US investment grade have widened 17 basis points. Over the same period, high yield has widened only 11 basis points.
We’ve talked before about the risks to the US corporate bond sector that we see. US corporate debt is near record highs, while spreads remain near record lows. Given greater volatility this year, some fundamentals signal that high yield spreads should be wider, but there is an important technical aspect which has helped to keep high yield spreads tight.
High yield issuance has fallen quite a bit this year relative to last year, which has proved supportive for the market from a technical stand-point. Lower supply contributes to downward pressure on yields and spreads.
Worryingly, lower issuance doesn’t mean that the US corporate sector is deleveraging. Instead, corporates have been issuing leveraged loans, and the amount outstanding this year has grown to almost reach that of the US high yield market. The Bloomberg Barclays US High Yield index market capitalisation was $1,270bn at the end of July 2018.
Leveraged loans are debt issued by companies and have a rating below investment grade (S&P define a leveraged loan with a rating below BB-). They are generally senior to the company’s other debt, and are often used for M&A activity or leveraged buy-outs. Perhaps most crucially, they generally pay a floating rate of interest. Demand for leveraged loans by investors reflects concerns over higher interest rates and the desire to hold a floating-rate investment. At the same time, heavily-indebted issuers have taken on floating liabilities, over a period when rates have risen sharply.
Recently, the leveraged loan market might be starting to show signs of stress. The average clearing yield on these loans at issuance has been increasing this year, from around 5% at the start of the year to close to 7% in July. The ‘covenant-lite’ trend in the high yield bond market has also spread into the leveraged loan space. The amount of US leveraged loans that are covenant-lite sits at about 78%, up from 64% in July 2015. That equates to about $825bn of covenant-lite leveraged loans outstanding. It’s looking increasingly likely to us that the first sign of real US credit stress will be in the loan market, rather than the high yield market, particularly if the Fed hikes roughly in line with market expectations (currently a US hike in September, and 2 more by end 2019).