Corporate bond investors - Good returns for 2019 but can they be sustained?

2019 has been a good year for corporate bond investors with double digit returns for both investment grade and high yield bond indices (LQD 16.75% and HYG 11.95%) through the end of November. Investors dodged a bullet given growth, while slower, has continued to be positive, equities reached new highs, and the Fed flooded the market with liquidity and lower rates. All may seem to be well, but a closer look at the structure of debt markets suggests there are still increasing underlying risks. Now, heightened risks by themselves may not immediately change debt pricing. It should, but there usually needs to be a catalyst for investor to engage in significant repricing. However, higher underlying risks mean any repricing of spreads is likely to be faster and more extreme. (Charts are from IMF Global Stability Report October 2019.)

There are a few clear risk issues that are changing corporate debt markets:

• Debt is not being used for new investments but as earnings pay-outs and buybacks. 
• LBOs and M&A have further fueled the corporate debt build-up and has not abated. 
• Debt risks are increasing with earnings adjustments that cannot be sustained, increases in goodwill and intangibles, and costs savings that will never be realized. 

Levered loans, covenant lite offerings, and non-bank "shadow" lending is a global issue. There are few places that will be safe from a credit cycle downturn, albeit some countries have shown more lending restraint than others.

The composition of corporate debt is highly variable. The Euro area and China are still very bank loan dependent while the composition of corporate debt is more diverse in the US. Different compositions have their own set of problems. US markets will be more sensitive to any liquidity run in funds. Euro banks already have funding and asset/liability mismatches that create significant risks for regulators. China is a complex levered market that cannot be solved by painless government intervention.

Under this background, investors are still searching and reaching for yield. Perhaps buyers are being more careful given the growing dispersion between high and low quality issuers, but the corporate leverage increases are fueled by investors willing to fund this borrowing. Still, there are significant risks if there is a liquidity run by these investors. A liquidity crisis is easy to see coming. The buyers of today decide to ask for cash from their illiquid fund investments. Without marginal buyers, the price adjustments will be painful.

There is no way of saying that there will be a debt repricing this month or next quarter. All we can say is that underlying conditions are troubling. Think of this like a California fire; you can say when the spark will come, but tinder, dry conditions, and a lack of preparation will only make the inevitable fire worse.