Rumors of credit bubble only partially exaggerated

May 28, 2013

By Agnes T. Crane and Neil Unmack
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

Rumors of a credit bubble are only partially exaggerated. Tell-tale signs of a boom seem to be everywhere. Yet, most investors aren’t panicked. Who’s right? Breakingviews offers a bubble-meter for the credit market.

Raw yields aren’t a clear indicator. Central-bank buying helps keep returns down on government bonds so fixed income investors who want higher returns have to buy debt issued by companies more prone to default. The dash for yield makes a bubble more likely.

The five-part bubble-meter marks on a scale of one to 10, with one indicating ridiculous caution, five healthy moderation and 10 a mania in the style of 2007.
1) Are yields too low?

The premium investors charge to compensate for default risk has fallen by nearly a percentage point on average, helping to knock down yields to around 5.5 percent, according to JPMorgan. Moreover, there are signs that investors are failing to discriminate between borrowers. The 3 percentage point premium for bottom-of-the-barrel CCC-rated debt over comparable single-B paper is less than half the historical differential.

As of May 17, U.S. junk bond spreads were 1.33 percentage points too low to compensate for default risk, according to a model devised by bond veteran Marty Fridson. But then again, the average junk spread in 2007 fell to 2.5 percentage points, a little more than half today’s levels. Bubble rating: 8/10

2) Is there too much debt?

A surge in high-yield issuance is normally a pretty good sign of a bubble. There has certainly been a lot recently. So far this year global high yield bond sales have topped $200 billion. That’s already above the highest full year in the last cycle, according to Thomson Reuters data. Leveraged loans are also smoking hot, with new issuance on track to beat the $688 billion high-water mark hit in 2007, according to LPC data.

But there’s a hopeful caveat. New leveraged buyouts aren’t driving the fundraising. Much of the recent burst has actually been risk-reducing, as companies have refinanced old debt at lower rates and longer maturities. For example, in 2009 a seemingly-impossible $204 billion worth of debt from junk-rated U.S. companies was set to mature this year. Thanks to refinancing, the actual sum will be a tenth of that. Bubble rating: 7/10

3) Are terms and conditions too generous for borrowers?

In hot markets, issuers can get away with higher leverage ratios and looser lending terms. Currently, they are doing both.

The average debt-to-EBITDA multiples on U.S.-sponsored LBO deals has averaged 5.5 times this year and last, up from 4.2 times in 2009, according to LPC. Yet it’s still below the 6.5 average in the 2007 LBO peak year. Meanwhile, issuance of so-called covenant-lite loans, which give lenders weak or no enforcement rights when borrowers’ profits fall, has soared to all-time highs. And issuance of particularly lender-unfriendly Payment in Kind (PIK) loans was up around 13-fold last year from 2010, according to Morgan Stanley. Bubble rating: 9/10

4) Are financial engineers too active?

In the last credit bubble, banks’ whizz kids created imaginative securities – collateralized debt obligations, structured investment vehicles and complex derivatives – to juice up leverage and inject liquidity into markets. In 2006, global CDO issuance reached half a trillion dollars. In the first quarter of this year, only $23.5 billion have hit the market, according to SIFMA.

True, exchange-traded funds are booming, but they mostly don’t use leverage. Still, the ETFs are untested in a downturn, and a rush to sell could precipitate a rout. Even if financial engineering is subdued, the growth in funds owned by retail investors, like mutual funds, could be a source of turmoil. Bubble rating: 4/10

5) Are investors too complacent?

When credit conditions are loose, even the weakest companies can find funding. That puts a lid on defaults and breeds investor complacency. In 2007, defaults were less than 1 percent of outstanding debt defaulted. Two years later the ratio was over 8 percent.

Cheap funding provided by central banks has kept defaults low, even though GDP growth has been slow. The average default rate for single-B credits over the last four decades was 5 percent, according to Deutsche Bank, but only 1.6 percent in the last decade, despite two financial crises. In a world where credit risk is banished, investors are bound to get sloppy. Bubble rating: 7/10

Tot it all up: there’s an abundant amount of cheap debt on increasingly loose terms. But the unweighted average score of seven on the bubble-meter indicates credit markets aren’t yet showing the kind of excesses seen in the 2006/2007 boom. The bad news: it may not take long before they get there.

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