Morgan Stanley: "A Credit Bear Market Has Started And Will Be Painful"
Authored by Vishwanath Tirupattur, Morgan Stanley's head of Fixed Income Research
As the Cycle Turns…
It is that time of the year again – time to review how the year has been and for strategists like us to return to the occupational hazard of crystal ball-gazing about the prospects for next year. Corporate credit markets, particularly in the US, are heading to a notably negative return year. Notable because it is a dramatic reversal of fortunes from a year ago and coming in a year of strong growth in the US economy, with defaults and ratings downgrades at rather benign levels. It is worth noting that this reversal of fortunes is precisely what our US credit strategists had predicted for this year. They now expect this bearish turn to continue in 2019.
The tricky handoff from quantitative easing (QE) to quantitative tightening (QT) that is under way is central to the cracks that have appeared across risk markets and credit markets in particular. Global QE provided the necessary conditions for corporations to lever up, which is exactly how they responded.
Outstanding US corporate credit market debt has more than doubled from US$3.2 trillion in 2008 to well over US$7 trillion today, with the biggest chunk of it coming in the BBB portion of the credit curve, the lowest rung of investment grade ratings. High debt growth has translated to high leverage – BBBs with 31% of BBB debt leveraged at or above 4.0x.
Lower yields driven by QE had important consequences for investor behaviour as well. The search for yield became a driving force which led to substantial inflows into US credit, particularly overseas investors. Also thanks to the Fed emerging as a large non-price-sensitive, programmatic investor of agency mortgage-backed securities (MBS) as part of QE, fixed income investors became progressively underweight MBS and overweight corporate credit. As the cycle got extended, the net result of these flows into credit investments has seen the manifestation of late-cycle excesses in credit markets. High debt growth has led to high leverage and weak structural protections for credit investors.
With the transition into QT, these flows are reversing. We have a marked drop-off in 2018 of foreign investor flows into US credit investments.