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The decade following the financial crisis was one of a long, slow recovery. As we enter the eleventh year of growth, the hot topic in the financial papers is when – and how – the wheels will fall off. Right now, the number one proposed canary in the mine is corporate debt: the concern that high borrowings by companies may be a current source of market vulnerability.
At a glance, it’s an easy story to stir up.
Since the financial crisis we have seen a growth in the leveraged loan market – these are loans made to highly indebted companies. Previously many of these companies borrowed by issuing high yield bonds, but in recent years, the leveraged loan market has outgrown the bond market. Loans offer borrowers lower costs and greater repayment flexibility than bonds and have become less restrictive in their contractual terms. What’s more, whereas banks once held these loans, there is now a new lender base in the big pension funds and insurers, attracted by a history of steady returns with more limited losses on loans than bonds.
This is one of the shifts that has made some people nervous as it was felt, rightly or wrongly, that banks knew what they were doing and were regulated. The new lenders may not be entirely unregulated, but what these pensions funds and insurers are doing collectively is not subject to the same supervision. The worry is that that risk among their ranks will be harder to spot.
Another corporate debt weak spot making headlines is investment grade bonds – the so-called blue chips of the credit market. Before the financial crisis, the bonds issued by the lower quality companies within this market – those rated BBB – amounted to less than USD 1 trillion. Today, the value of bonds clinging onto the lowest rung of investment grade has grown to more than 3 trillion US dollars. In the same period, the high yield bond market has seen a more moderate growth from just short of 1 trillion US dollars to slightly more than that figure.
Why is this a concern? If a company that is rated BBB goes through a difficult time and its credit worthiness deteriorates – something which is common if the economy weakens and goes into recession – it will become a ‘fallen angel’ and will be downgraded to a high yield rating.
When the markets were closer in size, the high yield market would be well positioned to absorb these downgrades, which are often good opportunities for the high yield investor. But if we were to see a similar wave of downgrades today, the high yield investor base may be overwhelmed, requiring significant price discounts to find incremental buyers.
It’s clear that not everything is rosy. However, the fact that lenders to both low investment grade companies and the new wave of leveraged loan borrowers are increasingly one and the same, may lead to a less panic-stricken reaction to the next credit downturn.
Pension funds and insurance companies, unlike banks, have liabilities to pay over many years into the future, not deposits to be repaid at very short notice. The guidelines that govern how these lenders respond to credit deterioration are also more accommodating today than in days gone by, such that bond sales at any price are less likely. Although it’s important to maintain awareness of the market mood, it’s equally important to not be distracted by it.
At Baillie Gifford, we use valuations and the prospect of returns over a multi-year period as our guide on how to act. When it comes to deciding on any individual bond issues, we are always looking to lend to resilient businesses with attractive yields. When yields are relatively low, as they are now, we move the bar higher and focus on quality in our portfolios. If the credit cycle turns, we are confident that we will be well placed to identify and accommodate the next wave of opportunities for our clients.
All data is to 31 March 2019 unless otherwise stated. The views expressed in this blog should not be considered as advice or a recommendation to buy, sell or hold a particular investment and it does not in any way constitute investment advice.
This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the fund, and any income from it, can fall as well as rise and investors may not get back the amount invested. Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the fund invests may not be able to pay the bond income as promised or could fail to repay the capital amount.
Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. This blog contains information on investments which does not constitute independent investment research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.
Issued by Baillie Gifford & Co Limited which is authorised and regulated by the Financial Conduct Authority (FCA).
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