Leverage Sets the Stage for the Next Crisis

And leverage has been building up since the global financial crisis, contrary to most belief. So if you think the streak of bad luck Altice has been facing recently is just a one-off, think again.

When growth slows down and cost of financing picks up, companies that relied too much on debt get into trouble. If they have a systemic impact on the market, this risk can spread and affect other asset classes.

Until recently, investors were quite flexible regarding debt/leverage. In their quest for yield, HY was precisely the place to be while the macro backdrop was supportive and financing costs were low. A better macro backdrop and accommodative monetary policies have also helped a great deal.

Now it seems the tide is turning. People are expecting rates to rise further, and without inflation in sight, earnings growth could get squeezed absent more robust top line growth.

Of course, a number of observers don’t expect a sharp correction rapidly. Yet many brokers are trying to assess when the cycle will turn, what asset classes will be impacted and how investors should react in terms of asset allocation.

The problem with high yield is that it might be the « canary in the coalmine » for a number of reason. The first one is, as we said, HY has become very popular asset class for yield hungry investors. It has attracted massive asset flows for some time – but now the asset class is suffering outflows (in the tune of 6.7bn$ i.e. the 3rd largest week of HY fund outflows according to Bank of America Merrill Lynch). Another reason for attractiveness of HY was low default rates, thanks in part to improving fundamentals. HY indices today barely resemble their earlier versions in the early 2000s.

And of course, many corporate took advantage of falling interest cost and strong investor appetite to issue debt, many times to simply finance share buy backs, while their equity was richly priced in the market.

This is part of the vicious cycle that has been taking place the last couple of years.

In its latest annual report, the Bank of International Settlements warned that the global build up of indebtness was not sustainable.

« An overarching issue is the global economy’s sensitivity to higher interest rates given the continued accumulation of debt in relation to GDP, complicating the policy normalisation process », its economists wrote.

We are probably about to learn if major problems are going to expose to severe market correction and if central banks will be able to play their role of « lender of last resort ».

Size of high yield market

HY European market is about 400bn€ based on Citi European HY Market index which combines issuers in GBP, CHF and EUR.

The following chart from Goldman Sachs gives a more global view of the credit market (IG and HY) with issuers in US, GBP and EUR.

Source: Goldman Sachs

It’s interesting and surprising to see that in Europe, the spread on IG non-financial corporates is lower than the spread for financial corporate, while in the US it’s the opposite. US HY yield is significantly higher than EUR HY yield, which is also inferior to Emerging debt yield (in USD), US IG and US Agency MBS.

What impact on other asset classes ?

Historically there has been a connection between US HY credit spread and US equity volatility.

Source: SG Cross Asset Research

But the implication of higher HY credit spreads are wider. Per SocGen’s analysts, when spreads widen, the most affected asset classes are European HY credit, Europe ex-UK equities, Global EM equities, Japanese equities, US equities, US HY credit, Commodities.

Cash, Core Euro government bonds, US, UK government bonds and US inflation linked bonds tend to protect invested capital.

Source: SG Cross Asset Research

How do you protect from rising risk ?

When risks are rising, the best protection of capital is cash. Although its opportunity cost is high, this asset helps lower the risk of a portfolio and is a key resource to be redeployed to seize opportunities after a market correction.

Cash is the only asset that gives you the luxury to wait for Mr Market to give attractive prices, and those attractive prices are much in need but probably a long shot away when you consider current market valuation.

« Cash and government bonds benefit from the highest Sharpe ratios on average, while equities tend to suffer more historically », according to SG.

Additional information

Some charts on the current state of the credit market, from GS.

Source: Goldman Sachs

The fact that spreads are very tight means the asset class won’t generate high returns going forward and that it’s valuation is expensive. For an investor, HY is probably not the best way to generate decent return with adequate risk over the long term, considering the current level of spreads.