Capital Markets Update #16

Define a credit cycle. Many probably can’t, which actually isn’t surprising and yet therein lies the problem. Today we’re experiencing the byproduct of a relatively familiar motivation and/or general professional ineptitude that seeks to stoke fear amongst the masses, with almost rhythmic consistency, of an upcoming credit cycle.  Per usual, we blame pundits or surreptitious instigators for attempting to subversively manipulate market sentiment. 

By definition, a credit cycle commences when companies systemically fail to meet their financial obligations to creditors, ergo, the default rate on bonds and loans skyrockets.  That doesn’t mean the default rate rises slowly across the market or there’s a high-profile default by some portfolio company of a large private credit firm; we’re talking boom – a material jump in defaults.  Anything short of that and you have traditional market volatility. The cycle matures as companies repair balance sheets and general market health returns.  We can identify three legitimate credit cycles over the last 40 years, notably the Savings & Loan crisis of 1990, the dot-com bubble in 2000 and the GFC in 2008.  Not ironically, those were also recessionary periods in history. According to Moody’s, high-yield default rates climbed to 10.5% in 2001, 14% in 2008 and probably would have sat around 12% in 1990 for comparable “speculative debt.”  For reference, Fitch quotes current default rates for HY bonds somewhere around 2.5% - 3.0% as of 1/26, which is on the lower end of normal. 

To be very clear upfront, we have no idea how to value private SaaS companies which collateralize the concerning slice of Private Credit risk outstanding.  The good news is, generally speaking, the public is not widely exposed to this opaque market segment.  Additionally, and this isn’t good news it’s just a fact, we don’t have perfect insight into historical venture debt default rates – the best we got from Capital Group states private venture debt defaults are maybe 1.5x public comps.  Even still, elevated defaults amongst a slice of the private venture debt market are not rare whatsoever and do not initiate (that we could find) or adjudicate the commencement of a broader market credit cycle.  The SaaS risk the public is widely exposed to often has a pretty strong and relatively unlevered balance sheet.  Notable examples include Salesforce, which has $4B debt on a $105B valuation and $3.5B cash in the bank or ServiceNow which has $900M debt on a $30B valuation and $1.8B cash on balance sheet.   The median publicly traded SaaS company has $90M debt on a $3B valuation with $200M cash on balance sheet (all data according to Crunchbase as of 11/25). 

So, if broad defaults define a credit cycle, perhaps the balance between capital markets liquidity and option adjusted spreads represent the canary in the coal mine signaling gas before the boom.  For reference, the below stats are all from the Fed’s Non-Financial Corporate Debt liquidity tracker.  From Q1 1990 to Q4 1991, liquidity in the non-financial corporate debt space dropped from about $188B YoY growth to $57B YoY contraction.  Similarly, liquidity tightened from $400B YoY growth in Q2 2000 to $10B YoY growth in Q3 2002.  Finally, liquidity shrunk from $700B YoY growth in Q1 2008 to a $440B YoY contraction in Q4 2009.  But, liquidity is not a perfect indicator.  For instance, we saw liquidity in the corporate debt markets tighten by about $1.2T from Q2 2020 to Q2 2021 in the aftermath of the Covid fallout, just as we saw liquidity tighten from $700B in Q2 2015 to $275B in Q1 2017 during the Greek debt crisis / Chinese stock market crash.  In both cases, the markets weathered the storm, defaults bent but didn’t break, and values resumed their upward march.  So, you can’t necessarily say tracking the flow of funds in the debt markets provides a reliable leading indicator to avoiding an all-out credit cycle. 

If market liquidity is unreliable as a determining agent for the onset of a credit cycle, it can’t be said that credit spreads are any better.  If you were to invert a chart of high-yield bond spreads since 1990 and lay it over Non Financial Corporate Business Debt flows, they’d look the same (both FRED data). The problem is that spreads and liquidity are much more reactive to idiosyncratic, somewhat secular events (or what were then perceived to be), as opposed to fundamental market dynamics.  For instance, throughout the 18 months from June 2014 – Jan 2016, HY Bond spreads jumped from 3.50% to 7.75%, liquidity fell off, and yet the unemployment rate continued to decline towards 5.0% and the S&P 500 stayed flat.  There have been four instances since 2000 where HY bond spreads advanced more than 250bps in less than a year that did not result in a recession or impart any lasting damage on the S&P 500 trend (FRED data).  Like the equity markets, bond traders can reprice risk in an instant.  Because of this, tracking spreads is a better sentiment indicator than it is a recession indicator or credit cycle warning.  

So how do we go about calling the onset of a credit cycle?  It’s really quite hard to say.  One of the most significant contributing factors to the general capital markets stability we’ve experienced over the last two decades is the active market manipulation, often deftly executed, by an empowered Federal Reserve.  For instance, during Covid, while the HY default rate jumped to 8% at the 2020 zenith, it immediately plunged back to 2% in 2021 as the Fed enacted the myriad of liquidity measures at its disposal.  If you look back at the Fed’s activity during the crisis, it’s actually quite extraordinary.  Over a period of about six months, the Fed enacted initiatives to stand up multiple repo facilities, actively buy treasuries and IG bonds in the market, incent reverse repo usage, drop Fed Funds to zero, and many other critical market plumbing initiatives.  To highlight one innovation in particular, the Fed created the capacity to accept a broad array of collateral under a series of purpose-built repo facilities.  In a repo arrangement, you (as an institution) pledge securities and, in return, the Fed gives you cash – like a loan.  Under normal operations, institutions could traditionally only pledge Treasuries at the repo window.  However, these special purpose repo facilities created liquidity for a spectrum of collateral by immediately getting fed-backed cash to money market funds, primary dealers, commercial paper markets participants, even ETF’s, secondary market stakeholders and a main street lending facility (if you remember that one).  Just knowing an inelastic source of investment grade liquidity exists, on demand, in a time of crisis builds a solid floor under markets.  The Fed’s efforts and creativity during this period saved companies and jobs and lives nationally (we’re not trying to be dramatic, but this is probably true).  The point being, an active Fed using its tools can throw a ceiling on default rates and ward off a credit cycle often faster than market fundamentals can deteriorate. 

In summary, we caution market participants against kneejerk reactions to idiosyncratic events, often emphasized in headlines, which occur in regular working capital markets order.  Historically, it requires a material degradation of market fundamentals (like a huge recession) to bring about a credit cycle.  Anything short of that, capital market participants often clean up their own mess or the Fed steps in and helps solve the problem before the patient really gets sick.