Economic and market themes: 2014-05-23 Credit excesses everywhere
There are widespread signs of credit market froth. This is a telltale sign of top of the cycle or near top of the cycle excess. Think 2005, 2006 or 2007. The key bit here is that credit markets transmit distress in a way that equity markets do not because when the credit writedowns are forced onto banks, the knock-on effects are severe. Let me go through some of these signs of excess with you. As I do so, let’s be clear that the froth is largely due to investors reaching for yield due to excessively low nominal and negative real interest rates. Financial repression has consequences.
Yves Smith has a good piece out highlighting a few of the areas of credit excess I have been highlighting and a few more to boot. Her conclusion is that there are widespread signs of credit market froth. This is a telltale sign of top of the cycle or near top of the cycle excess. Think 2005, 2006 or 2007. The key bit here is that credit markets transmit distress in a way that equity markets do not because when the credit writedowns are forced onto banks, the knock-on effects are severe. Let me go through some of these signs of excess with you. As I do so, let’s be clear that the froth is largely due to investors reaching for yield due to excessively low nominal and negative real interest rates. Financial repression has consequences.
First, is my favourite market, high yield. I used to work in high yield and still believe it is a great market for investors and companies alike. Before there was a high yield bond market, many companies were simply starved of capital. Nevertheless, as with any market, credit quality can decline. And given that high yield credit is already ’subprime’ that can cause investors to take huge losses.
On Wednesday, I mentioned the fact that Triple-C rated companies are trading at record low yields. and that 40% of US private-equity deals this year have been over six-times EBITDA, which is the highest since the 52% we saw in 2007, just before the credit bubble collapsed. What I did not say, however, was that in Europe, private equity companies have paid an average of 10.4x EBITDA for companies this year. That is according to Standard & Poor’s Leveraged Commentary & Data. Last year the figure was 8.7 times and it was only 9.7 times in 2007, at the height of the credit bubble. This is according to the FT. What this tells you is that the risk that PE companies are taking is as high as we saw during the credit bubble last decade, sometimes higher.
In addition, deal structures are becoming increasingly problematic as terms are increasingly dictated by the borrowers given that investors are starved for yield and will accept almost anything to get that yield. In February, Moody’s put covenant quality at a 4.36 rating, down from 3.84 at the start of the year. 5 represents the absolute worst covenant protection for buyers. So 4.36 is close to the bottom of the barrel in terms of cov-lite. The FT reported that the Fed and the OCC believe that the dominance of cov-lite deals means “prudent underwriting practices have deteriorated”. The FT also reported that bonds without covenants around issuing more debt or dividend payments, known as “high yield-lite”, were 39% of issuance in February.
High yield bonds are normally callable at a premium to par to penalize companies for repaying a loan early because investors then have to go out and reinvest and need to be compensated for that reinvestment risk. The traditional one-year call protection penalty is now a six-month protection penalty in 2/3 of cases in deals in Q1. In April, the one-year call percentage dropped even further to 24%.
In Europe, another issue that corporate lawyers have been harping on is that high yield bonds are now pari passu with senior credit bank debt obligations. In 2010, Moody’s issued an all-clear on this particular development, writing “banks are also better positioned than bondholders prior to default through the leverage provided by their maintenance financial covenants, enabling them to step in earlier and securing some recovery advantage”. But the reality is that a default with banks and high yield investors pari passu will be messier legally and we don’t know what will happen. Michael Dakin and Philip Hertz, restructuring partners at law firm Clifford Chance, warned this week that the growth of the European high-yield market in the last five years with a pari passu position for high-yield investors with bank lenders was “uncharted territory”. Hertz says that in two to three years there will be a wave of restructurings and that “there will be no early warning signs and bondholders and their advisers will need to be light on their feet and understand the EU playing field.” This sounds like a disaster waiting to happen.
In the auto market, in February I said the subpriming of the auto market was troubling and it was a clear sign of froth as investors reached for yield. But the credit quality is decreasing as lending is rising and losses are mounting. In March, Amy Martin, an analyst at S&P told Bloomberg that, “we’re at this inflection point. Now that they are opening the lending spigot, it’s only natural that losses are starting to rise.” Delinquencies and vehicle repossessions are beginning to rise, just as delinquencies and foreclosures began to rise in the subprime housing market in 2005 and 2006 before the ultimate stop in 2007. Caveat emptor.
In terms of other risks, take a look at residential real estate. Yves mentioned a recent deal by Blackrock to find an exit strategy from its investment in residential property in the US. They are securitizing the rents and selling the fees on to bondholders. She notes two factors showing a deterioration in credit terms in these deals. First, “unlike the 3 previous rental securitizations, 5% of the homes in the securitized pool are vacant, meaning you have 95% occupancy in the pool versus 100% in the previous deals. Second, this deal no longer has an “eligible tenant” requirement, meaning there is no guarantee of the credit worthiness of current and future tenants. Those are big changes that could mean losses for investors down the line. And it is yet another sign of credit quality decreasing because Blackrock understands they can reduce covenants as the credit cycle reaches a peak.
Yves also mentions the move into peer-to-peer lending products and the return of CLOs to market. Her post makes for good reading. I would also mention equity market activities as signs of froth. The fact that pre-IPO companies are seeing an unnatural surge in valuation is disquieting. Uber, for example, is a great company. But it was supposed to be in funding talks at a $10 billion valuation last week, according to Bloomberg. Now that is a $12 billion dollar valuation just one week later, according to the Wall Street Journal. Pinterest is getting valued at $5 billion pre-IPO despite the fact that it has very little revenue, let alone earnings. It is still loss-making. That valuation is up 32% in seven months as it was valued at $3.8 billion back in October.
Fred Wilson, a top tier VC, told Tech Crunch Disrupt last week that markets were overvalued. Being a VC though, he concentrated on post-IPO and publicly traded companies.
“I think in general the public market valuations got too high, and then that went down into the private market, and the private market valuations got too high, and now the public market valuations are correcting, and now there’s a bunch of companies that raised money at really high valuations in the private market and they’re going to have to deal with that.”
One final bit here on equities. JD,com just IPO’ed and its shares were pushed up 20% as investors flocked to the company. The company is a Chinese Internet retail company akin to Amazon to Alibaba as Ebay. And it checks all the right boxes: China, Internet, Mobile, Growth. The problem is valuation. The company made $8 million last year on revenue of $20 billion after losing $277 million the year before. That gives the company something like a 3500x earnings multiple. As with Amazon, since it is a retail business, rather than a marketplace business, I’d like to see how it can expand margins enough to justify the valuation irrespective of growth. This is a bubble stock, pure and simple.
The bottom line here is that credit markets are stretched everywhere you look. I have given you multiple examples here of how. Equity markets are also stretched. And despite the bubble deniers, high growth technology shares have rich valuations for which some investors will incur significant losses. The fact that both equity and credit markets are stretched tells you we are in a general risk-on environment. But my concern is the credit markets because that is where credit writedowns can pile up, causing panic and crisis. I fully anticipate that when this cycle turns down, much of the excess I have highlighted here will show up as malinvestment and credit writedowns. And then we will just have to see if Tim Geithner was right, that the bailouts he performed have left us in a stable position. I have serious doubts.