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Is The Corporate Bond Market Overheating? Look At The Lenders.

Traders Magazine Online News, October 10, 2018

Keith Brakebill

Recently, a growing number of investors and market commentators have been advocating for caution in credit lending—rightfully so, in my opinion. However, despite the publicity this has received in the press, it appears that little has actually been done to clamp down on aggressive lending. Perhaps this should not be surprising since in practice, lending is done from the bottom up. Viewed at the individual borrower level, the plethora of recent deals may not look so bad, so why pass? After all, in many cases, company fundamentals—boosted by strong earnings—are solid and it stands to reason that many businesses may believe they can probably handle additional debt based on the current economic conditions.

We believe the trouble with this comes when everyone takes advantage of this opportunity. Then the total debt levels in the economy increase rapidly. We see this as highly problematic.Why? Rising corporate debt breeds instability, as any hiccup in the economy or markets can increasingly reverberate throughout corporate America and the real economy.

This is why we believe investors are wrong to focus on the state of borrowers in assessing the credit cycle. At Russell Investments, we prefer to focus instead on the state of the lenders, as this historically has been a much better indicator when assessing the market cycle.  Zeroing in on this, we see many indicators that are shifting from caution to outright warning status.

Corporate lending: Aggregate vs. composition  

There are two main perspectives we use in assessing corporate lending: aggregate amounts and composition. Aggregate debt, at least as a percentage of the economy, is not limitless, as it may eventually breed the aforementioned instability that can knock over the cycle and lead to painfully forced deleveraging. Certainly, changes in the economy and the composition of lending can alter what levels ultimately lead to instability, but in recent cycles, corporate debt levels have tended to peak at similar levels as a percentage of GDP (gross domestic product). We believe investors who ignore this fact are ignoring history at their own peril.


On the composition front, the signals appear mixed on the surface, but become more sinister as we dig deeper. What’s going on?

For starters, supply from the traditional high-yield bond market has actually been rather low given how well the economy has been going. We take this as a sign of some discipline in the market—and, at first glance, perhaps a decent reason to be bullish on this end. Unfortunately, this bullish assessment only goes skin deep. While lower-quality companies are not issuing many high-yield bonds, that doesn’t mean they aren’t levering up late in the cycle. Below investment-grade companies are instead issuing a lot of high yield loans. Why? Because it’s predominately where lenders are seeing the most demand. Consequently, they’re offering some of the most generous terms to some of the riskiest companies.

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