“The world economy is in its worst shape since the Great Recession. And medium- to low-grade corporate credits will not escape the drag of global malaise.” – Moody’s, September 25, 2015
All is not well in the “medium-to-low grade corporate credit market, and if a warning from Moody’s wasn’t enough, famed activist investor Carl Icahn (IEP) applied more pressure with his controversial and headline-grabbing 15-minute video, “Danger Ahead.”
We think it makes sense to be cautious in today’s gyrating market environment, which continues to face a number of tangible headwinds, not the least of which are stretched equity valuations, “broken” technicals, and worsening sentiment. The collapse in China’s stock market, its potential knock-on effects across the global banking system, the ongoing recessions in Brazil and Canada, and slowing growth in Australia and the African continent simply aren’t helping either.
Moody’s Analytics’ average expected default frequency metric for US/Canadian non-investment grade companies tells of a very ominous pattern that may recur in light of the significant weakness in the energy (XLE) and commodity arenas. The credit rating firm’s average expected default frequency metric has now reached 5.1%, suggesting that the high-yield default rate may rise materially in coming periods, well above the ~3% median of January 1996 through August 2015. This has us concerned.
But what has us very concerned is that in the two prior instances since January 1996 when the average expected default frequency metric surpassed 4.5% (1998 and 2008), as it has, the actual high-yield default rate at the eventual depths of the credit cycle turned out to be far worse, ~11% in 2002 and ~15% in 2010 (Moody’s, page 2). As in the two past instances, high-yield default rates may very well surge in the coming months, and a double-digit rate can’t possibly be ruled out, even as Moody’s says “doom does not necessarily impend.” Surging high-yield default trends tend to occur around recessions, at least in the US.
In our view, we’ve now entered the part of the economic cycle where credit analysis has become incrementally more important than equity analysis. The “Consider Selling List” we laid out in the January edition of the Best Ideas Newsletter is as relevant then as it is now. We said the following in the introduction of that piece:
Here’s what I want you to do right now. Go through each one of your holdings and evaluate their net balance sheet position (i.e. subtract the firm’s total debt from its cash positon). If the firm’s net debt position is massive relative to its market capitalization, it’s probable the firm may face abnormal selling pressure should the market itself come under attack by sellers in coming months. We think credit quality will be the source of alpha during the next few months, and sticking with the highest-quality firms could be a nice source of relative outperformance. Your “consider selling list” should comprise of the most leveraged equities in your portfolio.
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More recently, we outlined a list of upstream energy firms we thought were “The Walking Dead,” and we continue to believe the energy and mining sectors will experience the greatest default incidences. The business development companies (BDCs), similar in some respects to venture capital or private equity funds but open to all types of investors, may also face outsize pressure should defaults in the high-yield arena proliferate in what some are calling a slow-moving, but accelerating “train wreck.” Such companies include Prospect Capital (PSEC), Ares Capital (ARCC), Apollo Investment (AINV), TCP Capital (TCPC), Monroe Capital (MRCC), Oxford Lane (OXLC), PennantPark (PNNT), American Capital (ACAS), Medley Capital (MCC), and Harris & Harris (TINY), according to a list provided by Seeking Alpha. We’re staying as far away from these types of companies as possible.
Related ETFs: BDCL, BDCS, BIZD, FGB