July 2013
For professional investors only
The Fix
Evolving opportunities in corporate
credit
by Mihkel Kase, Portfolio Manager, Fixed Income
Corporates are moving out of the post Global Financial Crisis (GFC) deleveraging phase. Leverage
is rising, corporate health has peaked and credit risk premia have retraced to around fair value. At
this phase of the cycle investors may be tempted to book profits and head for the exit. We would
argue against this. We believe they continue to play an important role in client portfolios in delivering
yield and providing portfolio diversification, particularly in a time of equity market volatility and
uncertainty. We do however believe the next phase of the credit cycle will be more challenging
requiring active management of the type and amount of credit exposures held in an environment
where risks are on the rise.
Background
Post the GFC credit investors have had somewhat of a dream run. Easy monetary policy,
quantitative easing, and attractive starting valuations for credit provided an environment for strong
returns across credit markets.
In a perverse way corporate credit based assets were a net beneficiary of the GFC. Financial
institutions were (for the most part) bailed out by governments whilst the corporate sector reduced its
debt through the raising of equity and the use of operating cash flows. Corporate leverage was
lowered, default risk reduced and credit risk premium had repriced to provide investors extremely
attractive risk adjusted returns.
The pace of corporate balance sheet repair slowed and the emergence of shareholder friendly
activity began to rise. One gauge of this is to assess the “Corporate Health” of issuers over time.
This composite measure combines profit margins, working capital, cashflows, debt to equity market
capitalisation, interest coverage, return on capital, and debt coverage. As can be seen in Chart 1
below based on the US companies, corporate health has peaked and is fading indicating we are
crossing over from an improving to a deteriorating phase.
Chart 1: US Corporate health monitor
2
Deteriorating health
1
0
-1
Improving health
-2
-3
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: BCA, Schroders
Issued by Schroder Investment Management Australia Limited
123 Pitt Street Sydney NSW 2000
ABN 22 000 443 274 Australian Financial Services Licence 226473
July 2013
Forr professional advisers onlyy
Whilst not u
unexpected
d and not ne
ecessarily a
all bad news
s, the shift has
h been prrimarily as a result of
increasing balance sheet leverage and comp
pounded by
y slightly low
wer profit m
margins and lower return
on capital.
So, what does it me
ean?
It is importa
ant for invesstors to be aware of th e trend in corporate
c
he
ealth, but in our view should not be
overly conccerned desp
pite our exp
pectations th
he trend willl continue. Profits arg uably are at
a their peakk,
funding cossts are at th
he lows and leverage e
expected to rise to imprrove sharehholder value
e but in a
ape. Some
relative sen
nse corpora
ates remain in good sha
e key reason
ns for this vview are outtlined below
w.
Firstly, the starting poiint of the lev
verage is lo
ow. Using debt
d
coverage as a meeasure Charrt 2 shows
we are a lo
ong way from
m the exces
ssive level sseen in the lead up to the
t GFC. A
Asset coverage remain
ns
sound and despite som
me retracing
g it is close
e to the prev
vious peak in coveragee in 2004 an
nd a fair wayy
C lows.
off pre GFC
Chart 2: De
ebt coverag
ge
Source: BCA, S
Schroders
Secondly, ffunding cossts are low in absolute terms so ad
dditional pre
essure on inndividual co
orporates, at
a
least in the
e early stage
es, is quite low. Chart 3 demonstrrates the ou
utright fundiing cost is at
a decade
lows and hence increa
ases in debtt will be eassier to service and man
nage.
Chart 3: Yie
elds
Source: DataSttream
Schroder Invesstment Manage
ement Australia Limited
2
July 2013
For professional advisers only
Thirdly, default rates remain at low levels and lending standards have not tightened significantly
which is often the precursor to rising default rates. Chart 4 shows the correlation between the level
of lending standards (the ease with which corporates can borrow) and the default rate. In essence
easy lending standards support low default rates and reduced risk of loss by investors over the
medium term. Whilst poor lending standards can increase risk over the longer term due to
misallocation of capital, the eventual tightening typically leads the increase in defaults.
Chart 4: Lending standards vs default rate
Fed SLO survey vs. Default rate
100%
16%
80%
14%
12%
60%
10%
40%
8%
20%
6%
0%
4%
-20%
2%
-40%
0%
Apr-90
Jun-94
Aug-98
Fed SLO
Oct-02
Dec-06
Feb-11
Default rte
Source: The Federal Reserve Board, Moodys
Fourthly, investors are still being rewarded when adjusting for the default risks in credit markets
overall. Pre-GFC leverage was higher and credit risk premium lower. Today we have lower leverage
and risk premium remains at or above our breakeven levels (expressed as a rock bottom spread in
Chart 5).
Chart 5: Average margin to swap
ASM
Average Margin to Swap
600
500
400
300
200
100
0
AA
A
OAS to Swap (30/06/2013)
BBB
Hybrids (BB Ave)
Base Case Rock Bottom Spread
Barclays Capital
Global High Yield
Corporate Index (est
BB-/ B+ Ave)
Source: CitiVELOCITY AUSBIG Index, Rock Bottom Spread based on Schroders calculations and average duration of the
relevant pool
(Note: Rock bottom spreads is the break even credit risk premium required when adjusting for historic default and recovery
rates)
Schroder Investment Management Australia Limited
3
July 2013
For professional advisers only
Portfolio outcomes
With reduced yields on offer some investors may even be tempted to move further out the risk
spectrum to achieve their return targets. Whilst higher returns may be achievable by moving a large
part of a portfolio into the high yield segment of the universe, this would significantly increase the risk
of the portfolio. In contrast we would currently advocate lower risk positions. Underpinning our view
is the fact that investors are in one sense being paid to wait. They can still access yield (albeit at
lower levels), reduce volatility and retain liquidity to buy assets as they reprice. In short our view is to
stay engaged and be patient and look for better levels to redeploy capital.
Conclusion
In our view these early changes signal investors should proceed with caution but don’t abandon ship.
Increasing corporate leverage does not signal the end of the credit opportunity given low starting
leverage, access to low outright funding costs, reasonable valuations and low default rates.
Opportunities remain for investors across the capital structure and across the risk spectrum. Credit
continues to deliver investors a source of income and portfolio diversification, particularly in a time of
equity market volatility and uncertainty.
Currently we are positioning our credit portfolios with high levels of cash and liquidity, moving up the
capital structure, holding shorter dated securities and maintaining a strong bias to investment grade
over sub-investment grade securities. This de-risking and large cash holdings allow us the
“optionality” to re-enter the market when a repricing of risk occurs which as we have seen recently
can happen in a relatively short period of time. In short, it pays to be patient.
Disclaimer
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In
preparing this document, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not
give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except
insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any
company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise)
for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or
otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be
relied on as containing any investment, accounting, legal or tax advice.
Schroder Investment Management Australia Limited
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