Framing up the credit cycle: Perspectives for insurers
June 8, 2015
In the asset management business, daily decisions are affected by a steady stream of information. Many factors are in play as investment professionals make their way through a changing mix of market conditions. Today, these conditions include uneven global economic growth, changing central bank policies, and near-zero interest rates in developed economies.
For investors who rely on a large allocation to fixed income securities, the give-and-take gyrations of the market are compounded by one additional factor: the position of the credit cycle. It affects portfolio-level thinking for managers and their clients, and insurance companies are no exception (especially in light of their growing allocations to corporate credit as a way to satisfy income requirements).
Where are we in the cycle?
In short, we think it’s fair to say that we are in the expansion phase of the credit cycle. Our assessment suggests that this expansion could last another two years or so, supported by factors that include:
- Credit fundamentals that are generally supportive (though we acknowledge a trace of evidence of deteriorating credit quality)
- Broad market technicals that have yet to show any significant signs of stress (corporate credit continues to see decent support, for instance, driven largely by a global demand for yield)
- Valuations that are tight to historical averages, which we think is appropriate in light of the technicals and fundamentals cited above
- Business cycle conditions that point toward modest — but continued — growth (here the metrics can be mixed, as evidenced by employment data that show improvements in hiring but no meaningful growth in wages).
The circumstances above indicate to us that the expansionary phase of the credit cycle has room to continue. Nonetheless, we acknowledge that a cyclical downturn could come sooner than expected, and it could be precipitated by developments that include:
- A persistently strong U.S. dollar, putting pressure on earnings for companies that do business in other currencies
- A stubbornly low rate of growth in corporate earnings, weighing on credit quality
- Oil prices that stay low enough — for long enough — that they eventually strain energy companies and steer them into the red (this could ultimately prompt an uptick in bond defaults, particularly among high yield issuers)
- Overly aggressive initiatives from bond issuers, such as acquisitions or recapitalization programs, that ultimately prove too costly to justify (low interest rates, which allow companies to borrow at favorable terms, are among the drivers here).
Overall, our base case scenario is that when the current cycle turns, credit losses will be less than they were during prior downturns. This is because we expect to see diminished systematic risk, which has caused significant market dislocations in the past. Chart 1 helps explain what we mean. It takes a look at peak default rates in prior setbacks and compares them to our forward-looking projections.
Chart 1: Credit losses from past cycles, and a look ahead
Data: Barclays; Delaware Investments analysis
Putting a finer point on it
Let’s review some vital signs that help frame our view of the current stage of the credit cycle. The balance of these signs is positive, with one negative signal mixed in. Enterprise valuations, for instance, are above their long-term averages, providing bondholders with an equity cushion. (This comes even as companies generally continue assuming elevated levels of leverage and debt.) Bond issuance is another positive area, particularly because new issuance in the high yield space does not include as much CCC-rated debt as it did during the last downturn. Furthermore, refinancing remains a major component of high yield issuance, which is another positive for extending the expansion phase of the current cycle. In 2007 and 2008, refinancing accounted for 35% and 40.5%, respectively, of high yield supply; in 2013 and 2014, those numbers reached 56% and 53.8%, respectively.
If there is one negative figure that we find noteworthy, it’s in the investment grade space. Here, we see leverage readings that we think are on the high side (see Chart 2), and we are closely monitoring them, especially because borrowers are enjoying reasonably easy access to capital. Data reaching back to 1992 suggest that today’s borrowing levels are above historical averages, and if the trend continues, we think any earnings declines will be particularly painful for issuers who are nursing overlevered balance sheets. Still, it’s worth noting that defaults remain low, and we don’t expect to see a rise until the economy slips into another recession — something that doesn’t appear likely in the near future.
Chart 2: A mild uptrend in gross leverage
Nevertheless, as noted earlier, investment grade debt earns itself a positive outlook on the whole. This view is supported by evidence that includes the following fundamentals:
- Interest coverage is significantly high, having recently reached record levels just north of 11 times (see Chart 3). This indicator suggests that issuers currently have satisfactory capacity to service their obligations.
Chart 3: Interest coverage at all-time high
Data: Morgan Stanley. Quarterly observations.
- Currently, liquidity and earnings margins are robust. Cash-to-debt ratios are well above historical averages, and margins are sitting very close to historical highs.
- As a percentage of revenue, overall capital expenditures are falling. Reduced spending is a tailwind for free cash flow in the near term, though we are also keeping in mind that a lighter commitment to capital projects can raise concerns if it stretches too far into the long term. (We think there is always a chance that spending will pick up again if energy prices see more support; the energy sector accounts for approximately one-third of total capital expenditures, and the downturn in commodity prices has probably provoked softer spending.)
- Although credit valuations are through long-term historical averages (excluding the 2008-2009 downturn), we believe current spread levels are justified by fundamentals, while the technical backdrop (augmented by healthy institutional and foreign demand) is supportive as well. We believe spreads (see table below) can retest their trailing 12-month averages or perhaps trade slightly through them. However, we do not expect levels to reach the tights achieved during the last credit cycle, even after adjusting for the duration extension that is currently in evidence.
- Compensation for duration risk remains at (or close to) historical lows.
- On a spread compensation basis, we continue to find valuations for BBB-rated bonds attractive relative to A-rated bonds.
- Absolute spread levels for BBB-rated issuers are through historical averages (see table below), which is a positive signal for the current stage of the credit cycle.
In summary: An unalarming point in the credit cycle
Broadly speaking, we believe there is ample reason to believe that we are in the expansionary phase of the credit cycle, and that it could continue for another two years or thereabouts. The evidence cited above points toward a continuation of healthy fundamentals, positive technicals, and market themes that support this conclusion. Overall, corporate credit — investment grade as well as high yield — continues to be a competitive source for yield. Yes, it’s a mature market, and spreads have recovered from the financial crisis, but that doesn’t diminish the likelihood that defaults will remain below median levels for at least two more years.
A closing word about our approach
As we help insurance companies guide their businesses through changes in the credit environment, we seek to provide the insight and perspective to make thoughtful, deliberate, and informed investment decisions. We focus on managing portfolios that are tailored to the unique income needs of insurers — driven by their underlying products as well as the needs of their customers — always with a focus on managing risk and preserving capital.
The views expressed represent the Manager's assessment of the market environment as of May 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Per Standard & Poor’s credit rating agency, bonds rated below AAA, including A, are more susceptible to the adverse effects of changes in circumstances and economic conditions than those in higher-rated categories, but the obligor’s capacity to meet its financial commitment on the obligation is still strong. Bonds rated BBB exhibit adequate protection parameters, although adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. Bonds rated BB, B, and CCC are regarded as having significant speculative characteristics with BB indicating the least degree of speculation.