Benjamin M. Lavine, CFA, CAIA
Investors exposed to lower investment grade credit risk take note. A perfect storm consisting of a tightening Fed, a flattening U.S. Treasury yield curve, and heavy corporate debt issuance from less credit-worthy borrowers is presenting an asymmetric risk environment for fixed income investors and corporate lenders.
According to Grant’s Interest Rate Observer, business debt as a percent of GDP has reached 72.3%, which has exceeded the last cycle peak of 68.8% in the 1st quarter of 2017 prior to the Great Recession. U.S. businesses have little margin for error should the U.S. economy falter.
And AT&T epitomizes this borrowing binge as its total debt load has reached $249 billion ($189 billion funded by the markets), making it the most indebted non-government, non-financial rated corporate issuer. This prompted Moody’s to downgrade AT&T’s senior debt from Baa1 to Baa2. AT&T prevailed in its anti-trust case against the Justice Department as a judge approved the acquisition of Time-Warner. This ruling may pave the way for other expensive, debt-fueled acquisitions as the media world races to lock in content. Equity holders cheered the decision, but bond holders may be left holding the borrowing bag.
Indeed, it’s never been a better time to borrow as U.S. Federal Reserve rate tightening is starting to close the window on easy financial borrowing. In a prior blog post, we highlighted the growing risks within the short-term lending market as below investment grade (high yield) bank loan issuance had exceeded traditional high yield debt issuance. Here we want to focus on the growing risks facing corporate and fixed preferred investors.
Figure 1 displays the growing risk presented to corporate lenders as BBB-rated issues comprise a multi-decade high percentage of the overall corporate borrowing market as well as a percentage of nominal GDP. In other words, just as with high yield bank loans, the U.S. investment grade market has grown riskier over the last several years due to the higher composition of lower investment grade borrowing.
Figure 1 – Composition of BBB-Rated Borrowing Has Reached New Highs
Source: Wells Fargo courtesy of Invesco
The good news for corporate lenders is that overall credit metrics still look benign, even for the most levered cohort of borrowers. “As the credit cycle enters its late stage, key metrics are stronger than before the start of prior recessions, pointing towards lower expected default rates in the near term,” according to Fitch Ratings from an early June report. Yet, storm clouds are forming on the horizon for corporate lenders despite the positive fundamental backdrop for corporate earnings.
Federal Reserve Rate Hikes Present Risk of Overshooting
We believe one of the biggest risks facing corporate lenders is overshooting by the Fed as they are projecting 3.125% Fed Reserve Fund Rate in 2019 based on the latest dot plot projections (Figure 2), and a positive growth outlook shared by Fed Chairperson Jerome Powell to a House Panel seems to confirm this projection even though Fed Funds futures are only pricing in a Fed Funds rate of 2.8% in 2019.
Figure 2 – Fed Funds Dot Plot Projections Imply Two Rate Hikes in 2018 and Two More in 2019
The risk to Fed overshooting has more to do with how the real Federal Funds rate tracks the theoretical neutral real rate of interest. As we pointed out in the New Neutral, the Laubach/Williams neutral real rate of interest, or the rate that supports sustainable economic growth without igniting inflation, is tracked by the San Francisco Federal Reserve, whose key input is the Fed’s estimate of sustainable real GDP growth. The core component of the personal consumption expenditure (PCE) inflation has risen to 2% on year-over-year basis and is projected to rise to 2.1% at the end of 2018. So, a rising core PCE has given the Fed cover to raise rates in a more hawkish manner than what the market is anticipating.
But sustainable GDP growth will need to rise in order for the neutral, or natural, rate of interest to keep up with the Fed. Figure 3 displays the estimated natural interest rate based on the FRS Laubach/Williams model along with the real Federal Funds Rate (“FFR”) which is the FFR less the core deflator for personal consumption expenditures (“Core PCE”). Currently the natural rate of interest is hovering just over the zero threshold. The prior two periods that saw real FFR overshoot the neutral rate of interest led to significant tightening of financial conditions that likely helped push the U.S. economy into recession.
Figure 3 – Unless the Sustainable GDP Picks Up, the Federal Reserve Funds the Risk of Overshooting in 2019
What is also noteworthy of Figure 3 is that the real FFR is now positive (albeit barely) for the first time since the 2008 Great Recession and that real FFR is expected to rise to 0.50% by year-end assuming two more rate hikes and core PCE of around 2%. Should the Fed follow through on its 2019 dot plot projections (ignoring Fed Funds Futures and the flattening 2-10 Year Term Structure strongly suggesting the Fed should be more gradual than the Dot Plot), then real FFR could ~1.1-1.2% in 2019. If the natural rate of interest does not rise (i.e. sustainable growth falters) with the Fed’s projected rate path, then the Fed runs the risk of overshooting by raising rates higher than what the U.S. economy can shoulder.
An Asymmetric Risk Profile Emerges for Fixed Income Credit Investors
The window for low cost borrowing on easy credit terms may be closing as the Federal Reserve remains committed to its rate hike schedule. So, a shortening of the credit cycle runway will likely begin with tighter financial conditions driven by the Fed, which will drive up borrowing costs. The issue then becomes which speculative grade borrowers can weather the higher borrowing costs assuming a benign macro environment (throw in a business cycle downturn, and all bets are off).
Even with the recent rise in BBB-rated credit spreads through the end of the 2nd quarter (Figure 4), the risks for owning corporate credit are becoming more asymmetric, especially in light of a flattening yield curve (10- vs 2-Year U.S. Treasury yields); a harbinger that the Fed may be close to overtightening on the short-end.
Figure 4 – Despite Widening During the 2nd Quarter, Credit Spreads Remain Narrow Relative to Recent History
The growing composition of BBB/Baa-rated issues held in many common corporate credit ETFs, such as the iShares IBoxx $ Invest Grade Corp Bd Fd (LQD), is also contributing to this asymmetric risk profile. The Baa composition within LQD has grown from 36.7% in June 2015 to 45.1% at the end of June 2018 (Figure 5). The corporate credit asset class has grown riskier as the share of BBB-rated issues has grown within common corporate credit benchmarks. And, up until recently, the compensation demanded by lenders (i.e. credit spread) had shrunk to historically low levels before rising in the 2nd quarter.
Figure 5 – Increasing Share of Baa Credit Risk in LQD
Investors in fixed rate preferred equity ETFs face even greater asymmetric risks because many preferred equity issues are now trading at negative yield-to-call or yield-to-worst levels. Using the iShares US Preferred Stock ETF (PFF) as a proxy, nearly 25% of the fund is invested in preferred issues trading at negative YTC/YTW levels (source: Bloomberg) as investors had bid up the prices to premium-above-par levels that would result in negative returns to holders in the event the issuer calls the preferred. So, fixed preferred investors face heightened credit risk and prepayment risk.
The macro economic and earnings backdrop may still look favorable for U.S. corporations, but a combination of Fed tightening (and increasing risk of overshooting) and high corporate debt levels are leaving little room for error should the backdrop turns less favorable. Investors in lower investment grade credit risk should reassess whether the risks look more balanced in equities than in corporate credit.
At the time of this writing, 3D Asset Management did not hold positions in LQD and PFF. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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