Kroll Bond Rating Agency Conference Recap in New York City
Here are the key takeaways from the recent event in New York City.
The Kroll Bond Rating Agency and New York University’s Stern School of Business joined forces recently to hold their very first credit conference.
The conference included keynote talks from several thought leaders. The list includes Stanford Graduate School of Business professor Darrell Duffie, President of the Boston Fed Eric Rosengren, and NYU Stern professor and bankruptcy guru Edward Altman.
All three shared their thoughts on where we are in the credit cycle right now.
The event also featured expert panels that included knowledgeable investors like former Citigroup chief economist and current Stern Professor Kim Schoenholtz, David McNellis, Head of Research at KKR’s Global Macro and Asset unit, Vishy Tirupattur, Head of U.S. Fixed Income Research and Director of Quantitative Research at Morgan Stanley, and Rachel Golder, Managing Director and Co-Head of high yield and bank loans at Goldman Sachs Asset Management.
Kroll Bond Rating Agency Conference Takeaways
While most felt that we were still in the long-lasting benign part of the cycle there were concerns expressed about what might happen in the high yield markets when we do finally see the economy slip back into a recession.
Kroll put out a report after the conference that noted panelists were concerned about the leverage loan market. Key takeaways from the event included the following.
- While most believe we remain in the benign part of the credit cycle, as the strength of the consumer continues to offset growing malaise on the manufacturing/services side of the economy, the margin for error is shrinking and vulnerability to exogenous shocks is rising.
- There is a genuine sense of uncertainty around how the next downturn will play out given seismic shifts in market structure, including the explosive growth in corporate credit, the size, and stability of the BBB category, the impact of shadow banks, the evolution of the loan market and its effect on CLOs, and the proliferation of passive investing strategies and ETFs.
- The consensus view is that recovery rates on defaulted loans are likely to be lower as a result of covenant-lite terms becoming the norm, and the size of single-B or worse bucket has ballooned.
- Liquidity has weakened materially as traditional market makers—the large global banks—have pulled back; for just that reason, most believe a downturn is unlikely to trigger a global systemic issue as was the case in the global financial crisis.
- CLOs may come under pressure to retain their stellar default performance as collateral losses are expected to rise on lower recoveries.
Digging Deeper into the Report
The report stated that “The leveraged loan market has grown rapidly on the back of strong investor acceptance of CLOs, which held up extraordinarily well in terms of defaults through the GFC; the market, however, has evolved into one that is overwhelmingly (80+%) cov-lite, average credit quality has dropped, and where a traditional layer of protection supporting loan recoveries, namely high yield bonds, has been displaced.”
There are also concerns about the tremendous growth in BBB rated debt.
This is the lowest rating in the investment-grade classification and many of these companies could be downgraded to junk status if the economy weakens.
The report also noted that “Professor Altman weighed in on the BBB problem and pointed out that, while fallen angels may be well bid, it could have a crowding-out effect on the High Yield market overall, which would bring into the question the quality of that shock absorber/liquidity provider. Altman’s view is that this might not end well.” Mr. Altman has been researching and following the credit markets for decades so his viewpoint carries a lot of weight with many market participants.
Participants were also concerned about liquidity in the markets. Kroll’s report revealed that “Explosive growth in corporate credit coupled with a dramatic pullback in traditional liquidity providers, i.e., broker-dealers, means pricing dislocations are going to be significant. In KBRA’s view, that is an unintended consequence of Basel III capital standards which required substantially more capital be held against broker-dealer inventory. It also acknowledges that hedge funds (which rely to some extent on leverage supplied by, and now cut back by, broker-dealers) are less likely to act as a meaningful shock absorber in a sell-off.”
The rating agency also concluded that while we are still in the benign phase of the credit cycle, to a very great degree we are also in uncharted waters.
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