Like animals in captivity, companies incubated on the milk of QE and low rates may no longer exhibit the natural behaviours needed for success in the wild of a stimulus-free market. Following the global financial crisis, pro-monetary stimulus policies slashed the cost of servicing company debt and encouraged firms to lever up their balance sheets. This may have allowed corporate financial alchemists to present ailing patients in rude health.
Unfortunately for bondholders, the elasticity of unreality has a snapping point. QE and ultra-low rates have insulated many companies, and unwary investors, from the dangers that normally lurk; they are now treading a dangerous path through the jungle floor.
While a crash or financial crisis may not be imminent, we are approaching the end of a cycle – the final chapter of a great monetary experiment. As interest rates begin to meaningfully rise, companies that have been able to borrow cheaply and roll over debt will be exposed. These are the zombie firms that in a normal rate cycle would no longer exist. Central bankers have inadvertently managed to stem natural attrition, something which is paramount for healthy capital markets, with a knock-on effect on the flow of money into new enterprises. Eventually, the natural order of things must prevail.
Defaults loom on the horizon
Towards the end of a cycle one would expect to see the revenant of defaults on the investment horizon. One alarming follow-on though is around the extent to which ‘covenant-lite’ or ‘cov-lite’ issuance has returned as a feature of the institutional market, making recovery on any defaults less likely.
Cov-lite arrangements place limited restrictions on the debt-service capabilities of the borrower to institutional investors, and are increasingly finding their way into the market. If you go back to 2009 approximately 2% of the loans issued were cov-lite, by 2010 it had risen to 10%, in 2013 we saw a big jump to 59%, and, in 2016, that figure rose to 75% (source: Thomson Reuters). This essentially means we have companies borrowing without due protection afforded to lenders, which they really should be demanding. This could be a potential powder keg under bond markets, and one that is highly reminiscent of the situation pre-2008.
Taking a step back for a clearer view, covenants are essentially restrictions on the management of a company and offer some protection to lenders. If yield-hungry investors do not seek such protection (or do not ask for premium to compensate for the absence of protection), then theoretically companies are under no obligation to offer them. But if it is true that greater instance of cov-lite today points to lower recovery rates in the future, then investors could be guilty of taking their eyes off the ball with danger approaching.
Signs of sulphur in the water?
Meanwhile, US investor data is throwing up some unnerving signs of sulphur in the equity waters.
Yale School of Management produces two instructive surveys on institutional investor sentiment. The first is on whether investors consider US markets to be overvalued – to which there is a high level of confidence. However, when you examine the results of another key survey – expectations of impending correction or crash in the next six months – we see confidence touching near historic lows. This is an anomaly: investors surely can’t hold together two near mutually exclusive ideas; markets are overvalued but a correction or crash is highly unlikely.
This is not a bull market dying on euphoria, but a market that may perish on investor complacency. And if structural concerns and a hubris premium were not enough of a concern for investors, they also have macro concerns to contend with. The maverick 45th US president has the potential to unleash a market-shredding political flashpoint, while a mounting credit bubble in China could fuel a market fire.
True active managers can restore confidence
As markets approach the late stage of the cycle, passive vehicles and closet trackers, which have enjoyed the directionality of markets, may suffer. However, in this more primal environment, genuine active beasts should thrive. In equities, this means holding conviction positions in quality names that can perform through the cycle, while in fixed income markets it means being flexible by widening your investment approach to navigate liquidity tides, assessing relative opportunities through the capital structure and taking a global perspective.
In an era where active management is under unprecedented scrutiny, greater market dispersion should provide the ideal setting for true alpha managers to restore lost credibility in active management. It is time for active beasts to return to the jungle.
Eoin Murray is head of Investment at Hermes Investment Management
Sometimes referred to as the ‘biggest manager you have never heard of’, Jonathan Boyd has caught up with PGIM for insight into its Europe region developments as part of global expansion