Corporate risk - Don't follow spreads, follow leverage and cash

Corporate spreads suggest that all is well in credit markets; however, the underlying fundamentals are not providing a rosy picture. This is not new information, but investors need a credit risk exit strategy. 

Leverage has been increasing and is at levels higher than the GFC and the tech bubble recession periods. High leverage exists for both investment and high yield credit sectors. 

The earnings to interest expense have been declining since the GFC even with low interest rates and low spreads. A turnaround to the pre-pandemic levels will not solve this coverage problem. There may be some income and balance sheet improvement, but corporate risk will still be high relative to the return to be received. 

This leverage problem should not be surprising given that over 800 companies in the Russell 2000 have negative earnings. Firms have borrowed to maintain operations or improve their current sector positioning. 

The trends in the graphs may suggest a slow increase in risk; however, there should be awareness that if there is a corporate risk revaluation the market reaction can be swift. There will be a non-linear relationship between risk and pricing. Every investor will not be able to exit the market at the same time. There is a strong liquidity mismatch especially given the size of corporate and high yield ETFs like LQD and HYG with respective market caps of $55 and $25 billion. A simple rebalance strategy may just try and outrun the corporate zombies when the repricing begins. A better approach may slowly reduce credit risk for some alternative carry trades.