Summary: The “old normal” ways of looking at credit as a major asset class have been shelved by new macro determinants, mainly QE.
Previously, investors and asset managers fretted about the risk-return trade-offs before allocating funds to an asset class. For credit specifically, that meant looking at default rates or the probability of default to assess risk – and summary measures that accomplished that, like spreads over risk-free instruments and assessing the economic viability of a sector or company. For returns, that similarly entailed a deep-down dive into sources of capital appreciation (spread tightening) as well as income return (coupons, roll-downs etc.)
In the new normal that we find ourselves in, growth on the US GDP front has been weak but consistent, housing is in a recovery mode and QE is in full-steam mode and tied to statistical targets for unemployment. Corporates have had the best earnings in a long time (although revenue growth has been weak as of late) and balance sheets are in excellent repair. Default rates on debt have also been at a low. Thus, with QE securing risk-free rates at very low levels and the state of the economy and its companies at a steady growth (and expected to increase as the economy improves), cash has been unsatisfied with the low rates (returns) in sovereigns and looking to earn greater returns across many an asset class. This is very different from the scenario that we found ourselves in a couple years back: cash eschewed returns (risk) and sought safety in risk-free sovereigns from the helter-skelter global markets and macro risks (Europe mostly). Now the macro risks are seen to have abated: Europe is in a much better place, China is back on a growth track, the middle-east tensions have cooled for now, and so on.
In this climate of low macro risk and low risk-free rates, investors are decidedly more adventurous in seeking returns. Credit has been the main beneficiary because the range of participants in credit is broader than that of other asset classes like equity or asset backed securities (ABS): credit has the full gamut of coupons (large and small), a variety of risk buckets and ratings as well as an entire duration spectrum to distinguish it distinctly. Thus, we have seen a huge tightening of spreads and yields across the credit spectrum as the investor seems to have adopted a “what, me worry?” attitude and we have seen systematic buying of credit, whether it be from ETFs, index funds, active funds, corporate treasurers, pensions etc.
What we should look out for is: 1) tail risk from new macro events that will drive fear and send people back to the safety of Treasuries; or 2) significantly higher leverage on corporate balance sheets while revenue growth stalls and EBITDA margins stay the same or decline. The second would presage an uptick in the default rate that would also be reflected in spreads.
But this trend appears to want to continue while low rates are here indefinitely, and while the economy is in trot-mode. I expect we will continue to see tight markets or markets going sideways for the next year to year and a half.