Understand credit risk is key to predicting the next recession
If you gave a credit investor a crystal ball in March of 2020 to look forward to a year, they wouldn’t believe the results.
Fourteen months ago, few people were prepared for the cataclysmic shift that was about to be unleashed on the market and reverberate through the world.
If you had told credit investors on March 18 the pandemic would last for over a year, they would have foreseen the end of corporate and consumer credit as we know it.
Investor Essentials Daily:
The Monday Macro Report
Powered by Valens Research
No credit analyst worth their salt would think after months of no restaurant visits, concerts, sports games, and more, that corporate credit would be intact. And yet, not only is corporate credit strong, but ratings agencies are predicting less than 2% junk bond default rates in the U.S. for 2021.
This is the lowest rate of default since 2017, and it is after months of strapped cash flows and unprecedented business uncertainty. This is why even if investors were handed a crystal ball back in early March last year, they would have been incredulous.
The fact that this is the reality of the corporate credit world is only thanks to unprecedented action from governments globally.
As a recent Bloomberg article highlighted, there has been upwards of $12 trillion combined monetary and fiscal stimulus in the U.S. since February 2020. With the floodgates open, it has been incredibly easy for investment grade and high yield companies alike to secure funding.
These names have issued $1.5 trillion of new debt in credit markets since the pandemic started, and that doesn’t even capture lending from banks, the government, and direct investments.
Despite this surge in new debt from the start of the pandemic, the yields on high-risk distressed corporate debt have fallen from 20% to just 8% today.
With rates so cheap, it became easier than ever for higher-risk companies to reevaluate their balance sheets and refinance their debt across multiple years.
The match that lights the powder keg of any prolonged recession is a credit crisis. Despite an economic crisis, swift government intervention prevented the pandemic from becoming a financial meltdown.
While default risks are forecast to be at record lows, this stimulus package did not change the way the credit cycle works.
Many investors fear with such easy credit, the Fed may only be amplifying the problem next year by giving more unstable companies more debt before they fail. Others fear that this easy access to capital has created soon-to-fail “Zombie Companies,” firms that should have been swept away by competition, but still exist thanks to government handouts.
Without the numbers to back it up, any forecasts on the future of the economy are just idle speculation. When we are looking to understand the credit risk for an individual company, we turn to our Credit Cash Flow Prime (“CCFP”) analysis.
When thinking about the market as a whole, we can aggregate all of the data for companies with debt trading, to build an aggregate CCFP to get the same level of insight. We can use this data to understand the strength of credit and the foundation of the economy.
Similar to our individual company analysis, in the chart below the stacked bars represent the S&P 1000’s obligations each year for the next five years.
The S&P 1000 is the thousand smaller companies than the S&P 500. We focus on small and mid-cap companies as the S&P 500 tends to have companies that are so safe and liquid that it washes out any insights about credit trends.
These obligations are then compared to cash flow (blue line), cash on hand at the beginning of each period (blue dots), and undrawn credit revolver (blue triangles).
As you can see, in this riskier segment of the market, cash flows alone still cover all obligations other than potential share buybacks through 2023. And even in 2023, cash flows alone cover almost all capex, along with all other corporate obligations.
Critically, these companies also have cash on hand to cover all obligations, including outstanding debt, through 2024.
By looking at this Aggregate CCFP for the next few years, we can see that in general, companies will have little issue handling their obligations over the next few years.
In the near-term, with unprecedented government intervention, companies are still safe. Last week, we highlighted how there may be some short-term volatility over the next few months, as the market’s expectations begin to outpace reality.
However, this doesn’t mean investors should panic in any pullback.
Thanks to this strong credit position, there is little threat of a protracted recession laying waste to your portfolio. Due to easy credit, the market quickly bounced back in 2020. With credit still strong, any dip is a buying opportunity, not a reason to run for the hills.
Best regards,
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
