“How did you go bankrupt? Two ways. Gradually, then suddenly.” – Ernest Hemingway
The transmission of credit austerity through higher rates has been very slow. All the more than (a) households and corporates had been gorging on cheaper credit prior to rate hikes, and (b) economic growth remained super-charged by a combination of strong economic stimulus and pent-up demand, to this very day.
Borrowing at high rates does not make sense, unless you need to. As always, borrowers with lower credit quality get hit first.
According to Fitch, delinquency on subprime auto loans has just surpassed 2020 level, setting itself at a 30-year high, with 6% of borrowers at least 60 days behind on their car loans.
Elsewhere in leveraged loans, instruments are mostly on variable rates, and are resetting higher. As a result, interest charges increased following the rate hikes., and interest cover ratios are becoming thinner. Moody’s estimates that 62% of issuers will be below 1x by Dec23.
In the meantime, credit quality has been deteriorating as a function of slower growth for smaller businesses. In leveraged loans, the lower-rated category of B-rated loans now represents 65% of the market, highest in 10 years 🤯
A voracious appetite for higher yields in private credit had propelled issuance in a low-interest environment. Leveraged loans issuance was almost on a par with investment grade bond issuance from 2012 to 2022. Loans structured at the top of the market, are likely to become non-performing and be restructured.
On average though things look artificially under control, default rates remain low, and leverage metrics look good. According to Oaktree “The average debt-to-EBITDA ratio for U.S. leveraged credit was around 4.0x at the end of the second quarter, down from a high of 6.5x in 4Q20 and just under 5.0x in 4Q19. While average interest coverage ratios have deteriorated over the last year, the current levels – 5.3x for U.S. high yield bonds and 4.5x for U.S. leveraged loans – aren’t sounding alarm bells”.
Remember though the story from Oaktree’s boss Howard Marks himself of “a 6ft man drowning in a river that was 5ft-deep on average”.
There are reasons to believe that the contamination will spread. Rates continue to be high, global economy is softer, and refinancing wall is coming for most corporates in 2024, notably on leveraged loans🧱
How bad this will hit consumers is a function of their savings, the sturdiness of the job market, and the stabilization of inflation. So far, so good according to data this week, still pointing to low employment claims and core PCE price at 2.5%.
Clearly, savings have been tapped into to finance the latest consumer binge. The Sep23 personal savings rate as % of disposal income dropped to 3.4%, flirting with the 6-year lows.
Private credit is likely to go through a restructuring phase, asking for looser covenants to navigate a tenser environment.
Riskier deals have been pushed out to the leveraged loan market, and high yield bond credits look that they have at least priced in higher rates, while spreads remain ~100bps tighter than long-term average. On balance, I’d stay away from old vintage private credit funds, and only allocate to new deals with sounder metrics.
I think the capital markets is trying to find some value in rate-sensitive sectors, including high yield, as it is sensing the end of the hawkish Fed policy. Utilities, real estate have been heavily sold off, and look ripe for a come back. I am less decisive on banks, which trade at pre-covid levels. They’ll remain sensitive to further credit deterioration, despite having provisioned accordingly so far. Tighter policy-driven capital constraints, as well as the unravelling of the US treasuries saga will continue to be tail end risks, in my view.
As for treasuries, the rate curve looks ready to de-invert. A mixed blessing for sure, as it catalyzes uncertainties on both Fed policy and economic strength. The rates-cession that we addressed last week has not finished to surprise us.
It is very likely that policy change will only follow a further deterioration in earnings and credit. Third quarter earnings confirmed that earnings have peaked and tempered forward expectations.
Despite the average suggesting that consumers are overall supporting a sturdy economic growth, the wind down has already started from the bottom, and will only accelerate. Rest assured though that some parts of the market have already priced it.
Stay safe out there !
360 Advisory LLC is a Boston-based RIA managing investments