Yes, Credit Is Probably Cracking

I keep hearing credit “hasn’t cracked yet” despite turmoil in rates, equities and FX.

That’s true. I guess. It depends on what you mean by “cracked.” The US hasn’t had a credit “event,” or at least not one large enough to land on the Fed’s radar, and spreads aren’t indicative of a crisis (even as yields have obviously risen sharply). But the situation is no one’s idea of sanguine.

For example, BofA and Barclays struggled to market nearly $4 billion in LBO debt tied to an Apollo-led deal for telecom and broadband assets this week, the latest canary in an increasingly dangerous coal mine which shuddered violently in September when underwriters ended up stuck with $600 million in losses on the Citrix deal-turned debacle. Those won’t be the last such tales. Banks are sitting on billions in commitments underwritten prior to this year’s macro turmoil. That financing will now be far more difficult to offload, assuming it can be sold at all.

Meanwhile, adverse market conditions continue to sideline issuers, hobbling the primary market in September, a normally bustling month. Just under $80 billion in high-grade deals priced, nowhere near expectations of $145 billion (figure below).

Just $1.7 billion in new IG debt was sold during September’s final week.

On the bright side, light issuance helped credit outperform last month, but the tumult across markets finally caught up to spreads this week. IG widened almost 20bps, the most since the initial pandemic panic (figure below).

“Our model for high-grade credit spreads calls for further widening from current levels driven by three main factors: Higher Treasury yields, deteriorating corporate rating actions and tightening financial conditions,” BMO’s Daniel Krieter and Daniel Belton wrote, in their Q4 outlook.

At ~165, spreads are the widest in two years. Krieter and Belton said their fair value estimate “is likely to only move higher as the dimming economic outlook leads to rating downgrades and Fed tightening continues to feed into financial conditions.” They cautioned that “crowding out of private debt as the market finds the clearing level for sovereign debt is another acute risk facing the IG market, as evidenced by the price action and policy intervention in the UK this week.”

Meanwhile, outflows continue apace. In fact, the exodus picked up speed during the latest weekly reporting period. IG funds bled $10.3 billion in the week to September 28 on Lipper’s data (figure below).

That was among the largest weekly outflows on record. Loan funds lost $1.9 billion, and junk funds shed $3 billion over the same period.

Over six weeks of withdrawals, IG funds lost more than $22 billion. The bleeding comes after a brief spate of inflows which snapped the longest weekly exodus on record.

Taken together, I’d venture the above suggests credit is indeed cracking. And with the exception of a malfunctioning Treasury market, credit distress is probably the biggest red flag for the Fed. Jerome Powell was concerned enough in March of 2020 to institute an unprecedented backstop for corporate borrowers, a decision that catalyzed a rapid rebound and a deluge of inflows.

And that’s the silver lining, I suppose. As BofA’s Michael Hartnett put it, the “big low” for stocks likely won’t come until there’s a recession or a credit shock. For the Fed and Treasury to panic, the US has to experience a credit event, he said, suggesting US shadow banking exposures, syndicated loans, real estate and illiquid PE are “all potential credit events to end monetary tightening.”

Hartnett’s colleague, Oleg Melentyev, on Friday cautioned that the bank’s measure of credit stress reached “borderline critical” levels this week. If the Fed doesn’t at least slow down, officials chance a broken market that’d be “difficult to contain and fix,” he said.