UBS strategist Matthew Mish simply asks ‘Is there a US corporate credit bubble?’, he then proceeds to look at the bullish and bearish cases.
The bullish case argues that fundamentals remain healthy and profits will not not decline materially in the intermediate term.
“Corporate fundamentals are deteriorating incrementally and from a relatively healthy position. US corporate debt to profits, assets and net worth do not appear extreme. While US corporate profit margins are elevated, they will not decline materially in the intermediate term – particularly if inflation remains sluggish and the Fed stands pat. Low government bond yields reduce the cost of interest payments, limiting refinancing risks and renewing the bid for yield.”
Meanwhile, the bearish case shows that issuance is way down and commodity-related issues will push default rates sharply higher. Further, leverage is at late 1990s levels.
Credit fundamentals, particularly in US speculative grade, are in a more dire state. HY issuance is down 53% in 2016, indicative of a substantial tightening in credit conditions. Commodity-related stress will increase default rates to 5.5%, and the broader universe is more leveraged than in the late 1990s. This leaves firms more vulnerable to peaking profit margins, rising interest costs, tighter capital markets and a slowdown in US growth. Market illiquidity and the zero bound create significant uncertainty around valuations in a downside scenario.
Overall, Mish believes there is a bubble in speculative grade credit. He said easy money from central banks limited credit losses in the last cycle, which kept many ‘zombie’ firms afloat. In addition, QE triggered substantial inflows into credit funds, igniting a material reach for yield. He said this translated into “elevated competition, easing credit standards, and massive issuance.”
Commenting on what is priced in, he said given the recent rally in HY bonds and leveraged loans they believe market implied pricing is largely consistent with the bullish view.