High Yield : U.S. corporate debt behemoth a threat?

The recovery that began in June 2009 differs from prior cycles in two ways: it is primed to be the longest cycle since the Second World War, and it also has the lowest average growth rate. Cycles do not die of old age and forecasting cycle length is highly challenging. But at this stage, it is all but certain that a slowdown is coming. Yet, a soft landing is the most likely scenario with GdP gradually converging to its potential growth rate in 2019 and 2020. Risks are sizeable and growing on the downside with plenty of external factors: global economic slowdown, political risk in Europe, and a challenging transition in China. As for domestic imbalances, even though households and financial intermediaries now have healthier balance sheets, the corporate side has accumulated a significant debt burden. In addition, credit quality on the aggregate has substantively deteriorated, marked by greater debt issuance in riskier segments of the market, weaker underwriting standards and negative downgrades. While a dovish Fed, low nominal rates, and still solid fundamentals can help mitigate this debt burden, monitoring it s evolution will be key in determining how long the current cycle lasts. Although the U . S . corporate tax reform has helped mitigating the deterioration in credit profiles of U . S . companies, we show that i / gross and net debt of U . S . corporate to GdP stand at very high levels historically, close to the peak of the previous corporate crisis of 2001-2002 ; ii/ the dynamics of FFO / debt for U . S . corporates are also worrisome; iii/ corporates’ liquidity has recently deteriorated; iv/ after massive inflows received in U . S . credit funds over the past 3 years, the latter have been posting outflows since the end of last year , particularly IG credit funds. Turning to g lobal U . S . high yield debt (or leveraged finance) markets, which include so-called leveraged loans and high yield bonds, those have substantially grown since 2009 . Several financial authorities (ECB, BOE, …) have recently warned over the rapid growth of High Yield debt markets and have expressed concerns over its recent and rapid development. As regards to the U.S. , the leveraged space is increasingly getting riskier . Indeed, l everaged l oans have attracted many investors over the recent years and fueled the leveraged space with riskier features . On top of that, the fast and recent growth of companies rated BBB is putting the leveraged space at risk of overwhelming Fallen Angels, even though the fundamentals and outlooks from rating agencies are still well oriented. We also point out the rising risk over CLOs in the U.S. while the market is poised for a new record issuance and CLO outstanding . Nevertheless, considering the still decent macro environment and persistently low default rates expected , we believe that CLOs are not a key risk for 2019. On the other hand , we express some serious concerns over the underlying leveraged loans in CLOs as we expect recoveries to be much lower in the event of default s, due to very permissive legal documentation and aggressive financial structures in LBOs.