Grant's Interest Rate Observer,

The Credit Markets Will Change.  

2018 Will Be  the Year of the Lender.

Auld lang sign

On the eve of the eve of the New Year, we pause to take stock – actually no. We pause to take debt, like seemingly everybody else with a loose dollar to invest.   By way of preview (spoiler alert!), borrowers have the upper hand the world over and have not been shy about throwing their weight around. As all things are cyclical, and as New Year’s forecasts are mandatory, we hereby anoint 2018 the Year of the Lender.  

 

Free climbing

 

Back on Nov. 21, S&P Global Market Intelligence’s LCD unit reported that the volume of U.S. institutional loan issuance reached a fresh record high of $468 billion, surpassing 2013 high water mark of $456 billion with more than a month left in the year. As the quantity of debt has reached a record high, the quality is plumbing new depths.  

 

LCD likewise relays that issuance of so-called covenant-light loans (meaning without certain contractual protections normally afforded to lenders) exceeded that of high yield corporate bonds by 36% in 2017 (for context, cov-lite issuance first exceeded high yield in 2016 after lagging far behind for most of the prior decade), while the share of cov-lite loans outstanding reached a record 75% of the S&P/LSTA index by the end of December.  Yesterday, the Wall Street Journal also noted the increasing pervasiveness of cov-lite, noting that 81% of loans in Europe have been of the cov-lite variety this year compared to just 21% in 2013 and quoting Adam Freeman, partner at law firm Linklaters LLP, who observed that private equity issuers “can be more aggressive and lenders will take it” amid “far too much cash trying to find too few homes.”

 

Under the table

 

In mid-December, the California Public Employees Retirement System (CalPERS) investment committee voted to change its allocation of its $346 billion investment portfolio.  Greater will be CalPERS’ exposure to the stock and bond markets; its allocation to public equities is set to increase to 50% of its AUM from 46%, while fixed income will rise to 28% from 20% (although direct comparison is obscured by the fact that inflation-protected securities will be consolidated into the fixed income category).  Lesser will be CalPERS’ dry powder: Cash holdings will decrease to 1% from its current 4% of the portfolio.   Bloomberg noted that the only dissenter in the vote, board member JJ Jelincic “has advocated for a higher risk portfolio,” while board member Richard Costigan concurred “I am concerned, we’re leaving money on the table.”

 

Public pension funds are rarely known for a contrarian mindset, and CalPERS is no exception.  The March 24, 2006 edition of Grant’s (“Billions buy funds”) detailed the California capital stewards’ foray into the then-blazing hot commodity realm, with the Thompson Reuters/CoreCommodity CRB Index having logged a 78% advance over the prior three years.  CalPERS’ didn’t top-tick the cycle, as commodity consolidation through the rest of 2006 gave way to a strong rally in 2007, but the party ended thereafter and by the beginning of 2009 the CRB index had dropped to those early 2003 levels. One day, California pensioners may wish that CalPERS had held more than 1% cash in 2018. 

 

Come on in, the water’s warm

 

The animal spirit-heavy emerging markets investment realm is the final stop on our year-end 2017 tour.  Last week, the Financial Times noted that investor flows and credit fundamentals are going in opposite directions: “Global investors have raised their holdings of emerging market bonds to a three-year high, even as average EM sovereign credit ratings have plunged to their lowest level since early 2010.”  

 

Beyond the aspersions of the ratings agencies, the timeless creditor kryptonite of inflation could be set for a resurgence, as bottom-scraping nominal yields offer investors little in the way of protection. Yesterday, the Argentine Republic raised its inflation target for 2018 and 2019 to 15% and 10%, respectively, from 10% and 5%. That sent the Argentinian peso jumping above 19 per dollar (since recovered to 18.6), compared to less than five per dollar at the end of 2012.   Argentina has defaulted eight times in the last two centuries (Almost Daily Grant 9;s, June 19), but holders of the 7 1/8s dollar bonds of 2117 are unconcerned.  The century bonds, issued at 90 cents on the dollar, have remained near their recent highs above 103, currently sporting a nominal yield-to-worst of 6.86%. 

 

The economist Herbert Stein once said that: “If something can’t go on forever, it will stop.”  We venture an opinion that Stein’s philosophy can be applied to today’s credit markets at large.   As to the timing of any such sea change, well . . . As much as we would like to furnish an exact month, date and year, we seem to have run out of space.