SocGen’s Andrew Lapthorne has talked a lot over the past several months about corporate leverage.

See for instance the following posts:

• One Bank Asks: “Who Will Burst This Bubble?”
• One Bank Goes Deep, Finds “The Major Performance Differentiator” For Stocks

In the latter piece, we highlighted the following chart from Lapthorne which shows that “the major performance differentiator in the US market so far this year is indeed Balance Sheet risk, with the strongest balance sheet stocks delivering a 13% total return this year versus the weakest that have only managed a 1% gain”:

That, we noted, is at odds with the following chart from the IMF which shows that credit markets aren’t punishing highly leveraged corporates whose ability to service their debt has become completely disconnected from spreads on their bonds:

Well on Thursday, Lapthorne is back to discuss this very same juxtaposition and his conclusion is both intuitive and troubling. To wit:

Leverage is historically high and while interest rates are gradually rising, credit spreads on high yield bonds have plummeted. Why? Well asset volatility is historically very low, or to put it another way, asset price confidence is high. This, coupled with the continuous clamour for yield, is then perhaps feeding a false confidence in credit markets.

Here’s more…

Via SocGen

Risk aversion, particularly to debt, has been a defining feature of equity market performance this year, especially in the US. Below we plot the long/short performance of our favoured balance sheet measure (Merton) versus changes in junk bond yields. Unsurprisingly both series (being measures of credit risk) are highly correlated. However today, US equity markets and debt markets are at odds with each other, US equity market investors are avoiding stocks with poor balance sheets, yet high yield bond yields are down at historical lows.

What drives credit is a typically a mixture of debt levels, interest rates, asset prices, and asset volatility. Leverage is historically high and while interest rates are gradually rising, credit spreads on high yield bonds have plummeted. Why? Well asset volatility is historically very low, or to put it another way, asset price confidence is high. This, coupled with the continuous clamour for yield, is then perhaps feeding a false confidence in credit markets. Any shift then in equity volatility could then be ruinous, not just for the equity market but for the credit market as well.