By Brendan Connor, CFA
We would like to offer a brief note of caution to those individuals investing in corporate credit today.
It is no secret that corporate balance sheets are very strong. Outside of the energy sector, the economic outlook also appears to be steadily improving. Inflation is low, and most credit instruments still provide a very healthy “spread” relative to historical levels. You know this and so does everyone else. That is why it has all been priced in.
Here is what hasn’t been priced in: Dodd-Frank changed everything.
Once upon a time banks provided liquidity to markets, in particular during periods of stress when the secondary market was either unable or unwilling to provide liquidity to support bond prices. Under today’s regulatory regime, banks are no longer able to play that role. In fact, bank dealers’ risk limits are constrained by the level of demand in the market. This means as secondary market liquidity dries up and prices fall, what drips of dealer liquidity are present in the market today will also evaporate. The simple fact is that banks’ ability to act as a buffer against market risk is gone. Markets are not discounting this new reality.
Credit markets have benefited from extremely accommodative monetary policy, which has left investors starving for yield, as well as steadily improving credit fundamentals. This has meant that liquidity in the credit markets has, until recently, been a one way street. So goes Warren Buffett’s famous quote, “After all, you only find out who is swimming naked when the tide goes out.” Liquidity can mask all manner of sins.
The big risk in credit markets may not be credit quality (at least for now). More likely it’s liquidity. While the Fed has been pumping liquidity into markets, regulators have been working furiously on changing the rules of the game. Dealers (banks) used to be big, and the market used to be small in comparison – that’s flipped; and the structure of those holdings is extremely alarming to us. The big consumers of credit have been mutual funds and exchange traded funds – both offering daily and minute to minute liquidity, respectively. This is a huge asset liability mismatch.
Markets may not be overleveraged today. Companies may be in pretty decent shape. But while that’s what caused the last crisis, it says nothing about what could cause the next one.
These sorts of structural issues have a way of manifesting themselves, which leads us to proceed with caution when positioning in credit markets today. We do not believe investors are being paid enough for the risks that exist today, and we can articulate any number of reasons why being long corporate credit could go very badly from here.
Dodd-Frank achieved one very important objective: it took systemic risk that was bottled up in a handful of highly leveraged banks and moved it to the market (you). Banks are a lot easier to bail out, in our estimation. In the end, it all boils down to liquidity.