Don’t Play the Cycle, Master the Names (Q3-17)
Sep 06th, 2017
The following was excerpted from Third Eye Capital Management Inc.’s Q3 2017 Investor Letter.
The macroeconomic backdrop of steady, synchronized global growth, low inflation, and ongoing corporate profitability has kept investor optimism high and blue skies for riskier assets like credit. We are in the eighth year of the post-GFC economic recovery, one of the longest expansions on record, and volatility remains at all-time lows. There are a chorus of experts warning that the business cycle has matured and that asset valuations have over-extended. With central banks now moving from quantitative easing to quantitative tightening, and volatility bound to increase, the skies will begin to darken for riskier assets. The tough question is when? If monetary conditions stay commensurate with economic activity, then riskier assets should continue to grind higher. Also, none of the typical recession timing indicators are warning of an imminent downturn. The Business Cycle Index (BCI), a proprietary indicator published by iMarketSignals that has predicted the past seven recessions in the U.S., currently estimates the probability of recession in the next 12 months at nearly 25%. This is the highest level for the current expansion but still relativity low by historical standards. Similarly, BCA Research sees a near zero chance of a recession next year based on its proprietary dynamic factor model, suggesting that the cyclical global bull market has further to run.
We know from past credit cycles that, in the final innings, tail risks move higher and challenges begin to appear in pockets of the market. One reliable late-cycle signal is falling correlations, when credit performance across sectors is no longer in sync. As monetary policy slowly tightens and liquidity buffer in markets shrinks, default risks begin to rise and problems within highly-leveraged sectors begin to surface. Looking at both high yield and leveraged loan markets today, some sectors like retail, energy, and telecom, are showing low correlations to the overall markets and greater default risks illustrated by widening spreads. Still, realized defaults remain conspicuously low (1.36% over the last 12 months), masked by the low cost of debt and weak loan underwriting standards. The loan default rate forecast for sub-investment grade and unrated debt by the end of 2018, based on LCD’s latest quarterly buyside survey conducted in late September 2017, is 2.42%. This is a muted increase given rising leverage and lower interest payment capacity among stressed issuers in the S&P/LSTA Leveraged Loan Index. Empirical indicators are all flashing red but with only a short list of borrowers with near-term maturities, the outlook for defaults remains benign. In fact, respondents in LCD’s buyside survey do not expect to see any recessionary pressure until 2019 or early 2020. This should not lull investors into complacency; instead, we should be vigilant about both credit quality (favoring businesses with scale) and collateral liquidity (emphasis on self-liquidating collateral).
The implication of these market signals to investors should be that credit selection is more critical than ever. Credit investors will find it tempting to buy names in lagging, low-quality sectors but valuations tend to overshoot on the downside when credit cycles turn. Fundamentals and structure matter, and indiscriminate buying of distressed loans is not going to work the same way it did in 2009-10. The erosion in protections for lenders over the past few years, and the greater relative bargaining power of borrowers, means recoveries on even first-lien loans will drastically disappoint investor expectations. Recent restructurings have revealed the pernicious effect that looser loan protections can have on creditors. Take the example of J. Crew, the private equity-owned apparel retailer. J. Crew took advantage of weak covenants in its credit documents to strip away its trademarks and brands from the collateral backing its senior secured term loans, and pledging it for new debt. Standard & Poor’s believes this transaction alone cut the likely recovery rate for J. Crew’s term loans to an unimaginable 15% in a bankruptcy!
According to Moody’s Investor Service, the average recovery for first-lien bank debt is currently at an astonishing 65%, its lowest levels in more than fifteen years, even lower than recoveries during the GFC. A frightening statistic for private debt investors that fails to attract any attention in a goldilocks market. Sentiment urges investors to get on the traded credit wave but investors should resist. Well-structured private loans will outperform traded loans and high-yield debt in today’s red-hot credit environment.
Our high selectively, in-depth due diligence, disciplined risk structuring and overcollateralization, our interpolation of operational expertise, and intensive, regular monitoring are all features of our process that are absent from traded credit. Zoom out of the horizon and look at what could happen when the cycle does turn and the benefits that the best private debt managers can provide will be revealed.