“Nobody goes there anymore, it’s too crowded”

With another quarter in the books, the credit cycle of 2014-2017 has completed its journey back from peak distress in February 2016 to today’s post-crisis low spreads. Only five quarters ago we were discussing the favorable excess return profile of credit and were asking for patience with the corporate and commercial mortgage-backed securities (CMBS) credits we had purchased. We are now at the opposite extreme, looking back at very strong returns and much more limited return potential ahead. With valuations of corporate credit and municipal bonds historically over-extended, we are now asking how much patience will be required before the next widening in spreads begins?

“Pass on Valuation” is presently the most common phrase in our group credit chat where we discuss the day’s offerings and other opportunities. Even though we aren’t participating in new issuance very often these days, we still enjoy a front row seat in various buy-side forums on Bloomberg and industry research. We have two seemingly contradictory observations.

  • We are far from alone (sadly) in our view of valuations and terms, yet,
  • everyone is buying credit anyway.

Again and again we see our buy-side colleagues protesting loudly about pricing and issuance, and the withering away of covenants (more on covenants below), yet these allegedly terrible values receive a warm welcome: “Oversubscribed, upsized, repriced” is this bond market’s version of “lather, rinse, repeat”. The contrast between fund managers’ expressed sentiments and the revealed preference in their purchasing made us think of the quip Yogi Berra immortalized: “Nobody goes there anymore, it’s too crowded.”

Well, many are clearly showing up despite the crowds, and the buying is louder than the complaining. Inflows into high grade bonds funds averaged $2.4 billion per week in the third quarter, and year-to-date flows are approaching $200 billion. What really matters is actions, not talk, and we will not attend overcrowded parties with lousy drinks. The only new corporate names we added this quarter were 2018 maturities. In asset-backed securities (ABS), where attractive spread concessions are still available, we participated in offerings by Willis Lease Finance (jet engines), and West River Group/Silicon Valley Bank (loans), and in CMBS we added to our position in a Hudson’s Bay single-borrower issue. Our sales of legacy positions, coupled with maturities and repayments, have become a steady drip from portfolios. Looking at our core strategy (as illustrated in the charts below), our spread duration (price sensitivity to spread changes) is down almost 40%, and down across all credit sectors.

  • Markets trend. We designed our process to take advantage of that fact. Our allocations change gradually, on a bond-by-bond basis. Rapid, top-down allocation changes are exceedingly difficult to get right, and often subtract value, as just about anyone sitting on an investment committee learns. Our risk profile increases or decreases gradually as valuations extend themselves in one direction or another. We still own credit, but it is increasingly confined to sectors with less froth, such as ABS, and shorter, less volatile credits such as liquid corporates under two years, and loans in place of high yield bonds. Our approach has worked extremely well for our clients over multiple cycles.
  • Reduced risk leads to reduced yield. Our valuation framework is telling us to be patient, the bonds we like will be cheaper sometime in the next couple of years. September was the first month of the last 18 in which many of our credit accounts lagged their indexes. Barring a sudden crisis, there will be more such months before the next widening phase begins.

A century of spreads – how long can this last?

Last quarter we described how our valuation framework showed that corporate credit valuations were breaking new ground post-crisis. We also described how today’s valuation levels have historically led to corporate credit underperforming U.S. Treasuries over the following 3 years. This quarter, we thought it might be interesting to look at an even longer history of spreads. In addition to illuminating today’s valuations, the longer term contains some lessons on how long spreads might stay low, and what keeps them there.

From 1919 to the present, there were some alarmingly long credit tightening cycles, one lasting 18 years starting in 1938, and others lasting 12 years starting in 1957 and 1986. These long tightening phases are the reason longer-term spread averages are lower than averages of more recent periods. Widening cycles are briefer, with the longest cycle starting in 1966 and lasting almost five years (see chart below)1 .


Today’s spread levels still look low in this context, but the long period of low spreads before 1966 is sobering. We think it is worth noting that both the lowest spreads and the longest cycles arose in this post-World War II period, when there was an unusually low default rate in corporate bonds. We would attribute this trough to low leverage and favorable economic conditions, and infrequency of recessions, with nominal gross domestic product (GDP) averaging +7.7% and inflation averaging about 4% annually (see chart on the following page).

Our view is that highly levered issuers in a highly competitive, low inflation, low growth world are going to run into problems more rapidly than issuers did in the post-World War II era. Inflation and growth reduce the burden of credit over time. Despite a low growth, low inflation environment, borrowers are bearing substantially more leverage today than they did in the 1950s and 1960s.2 Net debt to assets was actually negative in the 1950s, and only ramped up to contemporary levels only in the late 1960s. Higher corporate debt levels are a consequence of central banks’ massive liquidity injections, as global interest rate hover at record lows.

There are also a few visible cracks in this mostly calm credit environment. We’ve seen some restructurings and emerging distress in just the last few months, such as the Seadrill and Toys ‘R’ Us bankruptcies, a host of struggling retailers, and the continuing saga of Puerto Rico. Furthermore, there is no lack of exogenous risk in the Trump era, between North Korean saber-rattling, paralysis of the legislative branch, and rising trade tensions between the U.S. and the rest of the world. Finally, fund flows are a large as ever, and can drive markets to valuation extremes. Between slow growth, high leverage, and a huge amount of global capital responding quickly to a variety of global risks, there is ample reason to believe that we are still in the modern regime of credit cyclicality, as opposed to returning to pre-1966 placidity.

Rates and tapering

In October, the Federal Reserve (Fed) will begin a gradual reduction in the pace of its reinvestments in agency mortgage-backed securities (MBS) and U.S. Treasuries, reducing monthly purchases by $4 billion and $6 billion, respectively. This tapering will increase through 2018, with a target of effectively ceasing reinvestment by the end of that year, allowing the Fed’s bond portfolio to gradually shrink over several years through paydowns. The pace of tapering is exactly what the Fed advertised previously and the immediate impact on U.S. Treasury yields and MBS spreads has been moderate. The Fed even contemplates changing the maturity of regular issuance to compensate for the duration removed by tapering, suggesting a desire to leave a small footprint in markets. However, the withdrawal of the largest buyer from U.S. fixed income markets is likely to pose a negative technical and place some pressure on spreads, initially in the MBS market, but ultimately in rates and credit markets as well.


The U.S. Treasury yield curve made a round-trip in the quarter, ending back where it started, with only slightly higher short rates, reflecting the gradual tightening trend of Fed policy. Despite the lack of rate drama, it is worth noting that the 1-Year U.S. Treasury bill sits now around 1.34%, a level not seen since Lehman Brothers went under. A year ago it was about 0.6%. (see charts below).

What about HIM?

Although clearly devastating to those impacted by recent hurricanes Harvey, Irma, and Maria (“HIM”), the effect of windstorm and flooding damage on the performance of ABS and CMBS trusts should be modest. For most trusts, the underlying portfolios of consumer, commercial, and real estate assets are well diversified geographically and the debt benefits from sizable equity protections that insulate bonds from even substantial deterioration in underlying collateral performance. Unlike the debt of property insurers and reinsurers, ABS and CMBS spreads showed little volatility through the September landfalls (as shown in the chart to the right). Large auto lenders like Santander were able to redeploy servicing call centers nationwide to affected areas, and noted that auto collateral should be insured. They nonetheless estimated their disaster-related losses to pick up by 3.5% and 5% in Florida and Houston, respectively. There were no major impacts to more concentrated single-asset CMBS trusts, which nonetheless benefit from extensive property and business interruption insurance coverage.

Among our Property-Casualty names, Renaissance Reinsurance bonds widened as Irma approached Florida, but tightened again when the storm moved up the West Coast, avoiding a direct hit on Dade and Broward Counties. Renaissance Reinsurance and Sirius Insurance, our remaining exposures in property reinsurance, are likely to record substantial losses from HIM, due to flood cover in Houston, windstorm in Florida, and Puerto Rico property, but not in amounts that will affect capital significantly.

CMBS also had a pricing cycle, and more may be on the way

Non-agency CMBS investments were one of the largest contributors to our performance over the last 12 months. We invested consistently as CMBS spreads widened in 2014-16, bringing core concentrations as high as 25% (as shown in the chart to the right). Through the last 15 months, many of these have been refinanced and sold. For accounts that buy CMBS at all rating levels, the performance contribution was in the hundreds of basis points3, rivaling our corporate contribution.We are carrying fewer CMBS now, but the non-agency CMBS market passed a milestone in Q3. As the pace of maturities of 10-year loans from 2007 transactions diminished and new CMBS supply remained brisk (particularly in Single-Asset, Single-Borrower CMBS), net issuance of non-agency CMBS turned positive for the first time in several years. Given the relative lack of CMBS origination from 2008 to 2011, the outstanding issuance of CMBS is poised to grow meaningfully from this point forward. While solid crossover demand from investment grade corporates continues to keep spreads firm in new issue CMBS markets, growing market supply will add to the technical headwinds in CMBS markets coming months.

With valuations terrible in corporate markets, we are hopeful for another opportunity to capture value in this sector.


Reading the fine print

Rich pricing isn’t the only problem in the credit markets. The terms of credit are also weakening, and, while investors are belly-aching, issuers are meeting little real resistance. A few anecdotes from recent issuance illustrate the trend.

  • Discovery Communications issued $6 billion in multiple tranches of debt to fund their acquisition of Scripps Networks. The transaction takes them to a leverage multiple more typical of high yield credit (5 times EBITDA4 ), but Discovery remains at BBB- on the presumption that leverage will come down quickly. There isn’t much margin for error. Should we enter even a mild recession before 2019, a downgrade is very possible. Typically, issuers in this position don’t get terrific pricing, and often have to accept some covenants or terms, such as a “step-up” in coupon if the bonds are downgraded and some restrictions on pledging assets or removing asset protection. Discovery was priced finely and offered none of these protections. Industry chat rooms were alive with indignation about the pricing and terms. Investors vowed they would never give in to this sort of extortion – yet the offering repriced even tighter and was several times oversubscribed.
  • Public Storage (“PSA”), a Real Estate Investment Trust (REIT) of self-storage facilities, issued $1 billion in 5- and 10-year bonds. REITs typically come with limitations on secured leverage, but PSA’s covenant included a gigantic loophole, allowing nearly unlimited secured leverage. Fund managers raged and threatened to boycott, both before and after the offering, but PSA’s offering was also oversubscribed.
  • On the theme of weak covenants, Xtract Research and Covenant Review have taken the unusual step of highlighting several transactions that had exceptionally weak covenants, recommending investors boycott issuance. Xtract issued a special report on August 8, entitled “Aggressive Terms in Recent Credit Agreements” listing 20 different ways lenders are relaxing traditional lending terms.

Moody’s attempts to quantify the overall change in high yield covenant quality in an index which is presented below. While it is something of an apples-to-oranges comparison, Moody’s suggests covenant quality is deteriorating more rapidly than spreads.


Tax Reform 2.0

We are reluctant to assume that any proposal by the GOP-led Congress is likely to turn into law. Nonetheless, they have turned their attention to tax reform. The current proposal certainly offers what might be stimulative tax relief through lower brackets. It includes some arbitrary wrinkles – it favors pass-through income over other forms, and eliminates deductions for state taxes, which falls heavily on residents of the coasts. Lower corporate rates, and possibly reduced deductibility of interest, will certainly put a little more tailwind in the corporate bond market by perhaps prompting corporations to de-leverage and reduce supply.


As you can see above, our valuation discipline has caused portfolios to be more conservatively positioned than we have been for a while. Within this discipline we are credit-oriented: we spend most of every day looking hard at promising opportunities as they develop. There are still some good values in the portfolio and we are still participating in the credit rally, albeit in a much more tempered way than six months ago. In all likelihood, next quarter we will have to think of another way to describe the aging bull market in credit, but we are increasingly liquid and well-positioned should the bears emerge.

In the meantime, we look forward to meeting with you this quarter.

Andrew P. Hofer
Portfolio Co-Manager

Neil Hohmann, PhD
Portfolio Co-Manager

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IM-2017-10-11-4372 Exp. Date 01/31/2018

1 Individual bond data and spreads are not available prior to 1988. In the chart above, we estimate spreads prior to 1988 by subtracting averaged bond yields from on-the-run U.S. Treasury yields.

2 See “A Century of Capital Structure: The Leveraging of Corporate America”, Graham, Leary, and Roberts, October 12, 2012 (https://www.aeaweb.org/conference/2013/retrieve.php?pdfid=336).

3 A unit that is equal to 1/100th of 1% and is to denote the change in price or yield of a financial instrument.

4 EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is a measure of a company’s operating performance. Essentially, it’s a way to evaluate a company’s performance without having to factor in financing decisions, accounting decisions, or tax environments.