Guggenheim Investments assesses the risks of covenant-lite loans, 0% Libor floors, tax reform, and tightening spreads.
NEW YORK, NY – Jan. 18, 2018 – Guggenheim Investments, the global asset management and investment advisory business of Guggenheim Partners, today provided its First Quarter 2018 High-Yield and Bank Loan Outlook.
Among the highlights in the 14-page report:
- The lowering of bank loan London interbank offered rate (Libor) floors from a range of 0.75–1.25 percent to 0 percent puts loan investors at risk of earning poor returns in a scenario where the Fed returns to the lower bound in the medium term. We believe the market is underestimating this risk.
- Our primary concern for the average high-yield investor is in the limited compensation they are willing to accept for high-yield bonds. We estimate that an average high-yield corporate bond portfolio would earn little more than a current 10-year Treasury on a loss-adjusted basis.
- Given some of the negative repercussions of tax reform, we recommend that investors focus on companies with less than 30 percent of interest expense to earnings before interest, taxes, depreciation, and amortization (EBITDA), positive cash flow generation, and steady capital expenditures.
- Many of these same companies are tapping into primary markets to issue debt with fewer protections and at tighter spreads. Altogether, we believe these trends are creating a perfect storm for a significant shakeout in the high-yield universe that will not end well for the average high-yield investor.
- Now more than ever, investors should take a company-by-company approach to credit selection, and avoid making general decisions based on industry preferences.
For more information, please visit http://www.guggenheiminvestments.com.
High-Yield and Bank Loan Outlook - Be Wary of Eroding Investor Protections
We close out a record year of institutional bank loan issuance and a robust year of high-yield corporate bond issuance. Despite heavy volume, pricing power remains firmly in borrowers’ hands, resulting in a further relaxation in the investor protections that were prevalent after the financial crisis. This trend is compounded by tight spreads, which in our view offer insufficient compensation for credit and liquidity risk.
Rising leverage ratios and declining coverage ratios as the Federal Reserve (Fed) raises borrowing costs will amplify issuers’ vulnerability to adverse shocks. One such shock can be found in the recently signed tax overhaul. We estimate that 40 percent of the high-yield market will be hurt by the new limitation on net interest deductibility. Now more than ever, investors should take a company-bycompany approach to credit selection, and avoid making general decisions based on industry preferences.
§ The lowering of bank loan London interbank offered rate (Libor) floors from a range of 0.75–1.25 percent to 0 percent puts loan investors at risk of earning poor returns in a scenario where the Fed returns to the zero bound in the medium term. We believe the market is underestimating this risk.
§ Our primary concern for the average high-yield investor is in the limited compensation they are willing to accept for high-yield bonds. We estimate that an average high-yield corporate bond portfolio would earn little more than a current 10-year Treasury on a loss-adjusted basis.
§ Given some of the negative repercussions of tax reform, we recommend that investors focus on companies with less than 30 percent of interest expense to earnings before interest, taxes, depreciation, and amortization (EBITDA), positive cash flow generation, and steady capital expenditures.
The Party Continues, But Watch the Punchbowl
We ring in 2018 with the lowest unemployment rate since December 2000, the highest small-business optimism since 1983, strong corporate earnings growth (the average S&P 500 trailing-12-months earnings per share is up 12 percent year over year as of Nov. 30, 2017), and a new tax regime that will likely stimulate growth and business investment. Regulatory relief for banks is also in the offing, alleviating undue burdens on mid-sized lenders. All this positive news prompted the Fed to gradually raise rates toward neutral in 2017—the rate that is neither accommodative nor restrictive to the economy—but we expect that an overheating labor market will force the Fed to continue taking the punchbowl away in 2018.
The fourth quarter of 2017 saw the commencement of the Fed’s balance sheet roll-off in October and another rate hike in December, taking the fed funds target to a range of 1.25 percent to 1.50 percent. Soft inflation surprised many market participants in 2017, but we expect core inflation to rise modestly due to base effects, and end 2018 closer to the Fed’s 2 percent goal. With the unemployment rate likely headed to 3.5 percent, we think the net result will be a faster pace of Fed hikes in 2018 than policymakers or financial markets currently expect. Tighter monetary policy will, in turn, begin to put the brakes on the economy, bringing us closer to the end of the business cycle.
It is hard to identify just one area of weakness that will ultimately be responsible for toppling the U.S. economy into recession, but we have our eye on some fragile segments of the economy. The passage of the Tax Cuts and Jobs Act has been largely viewed as positive for corporate bottom lines, consumer spending, and business investment, but there has been less time spent analyzing the adverse effect of certain provisions within the Act. Among them is the change to net interest deductibility: Under the new bill, companies can no longer deduct all of their net interest expense from earnings before taxes are calculated. Net interest deductions are now capped at 30 percent of EBITDA, and in a few years this will become stricter with the cap calculated on earnings before interest and taxes (EBIT). Our review suggests this will affect 40 percent of borrowers in the highyield corporate bond market, and could create a tax liability for companies that previously may not have had one.
The change in net interest deductibility is expected to primarily impact the highyield market, while most of the corporate debt market remains untouched by this provision. In fact, many corporate borrowers stand to benefit from immediate capital expensing and a lower corporate tax rate. Borrowing will likely continue to grow at a time when the ratio of corporate debt to gross domestic product (GDP) is already at historical highs.
This brings us back to the vulnerability of the U.S. economy to a tighter Fed stance on monetary policy. We believe the Fed will eventually inadvertently push the United States into recession by tightening monetary conditions in an over-levered economy. This will most likely occur in late 2019 or early 2020. Our Macroeconomic and Investment Research team recently published a report, Forecasting the Next Recession, which provides an in-depth look at the many economic indicators that suggest a recession is about two years away.
Late-cycle credit standards in the loan market are also on our radar. For example, weak covenants in the loan market are now accompanied by 0 percent Libor floors. The high-yield corporate bond market has seen some pushback on poor structures that were prevalent in 2006 and 2007, but average high-yield investors have lost their discipline for determining appropriate compensation for both liquidity and credit risk. These trends make us very concerned about what lies in store for credit investors in the next downturn.
See the full PDF below.
About Guggenheim Investments
Guggenheim Investments is the global asset management and investment advisory division of Guggenheim Partners, with $243 billion1 in assets across fixed income, equity, and alternative strategies. We focus on the return and risk needs of insurance companies, corporate and public pension funds, sovereign wealth funds, endowments and foundations, consultants, wealth managers, and high-net-worth investors. Our 275+ investment professionals perform rigorous research to understand market trends and identify undervalued opportunities in areas that are often complex and underfollowed. This approach to investment management has enabled us to deliver innovative strategies providing diversification and attractive long-term results.
- Guggenheim Investments total asset figure is as of 9.30.2017. The assets include leverage of $11.6bn for assets under management and $0.4bn for assets for which we provide administrative services. Guggenheim Investments represents the following affiliated investment management businesses: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management.
This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC.