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MR. MICHAEL CEMBALEST:  Good morning.  This is Michael Cembalest with a July Eye on the Market podcast.  I want to talk about two different food fights going on.  The first one between the Fed and the Chair of the Federal Reserve and the second one the food fight regarding the issue of covenant light loans in the leverage loan market.

 

On the Fed, I don’t think there’s too much here to say other than it looks like Powell, for a combination of legitimate economic reasons and bullying reasons from the President, it will be delivering either a 25 or 50 basis point cut in July at a time of the lowest unemployment rate in 50 years. 

 

On the first page of the Eye on the Market, we have some sad and also humorous parallels between the things that Trump is saying about Jerome Powell and what Richard Nixon and his team of evildoers did to Arthur Burns, the Fed Chair in the early 1970s. 

 

We know what happened in the ‘70s, Burns caved in too many of Nixon’s demands.  The economy got a boost before the 1972 election which Nixon won forty-nine states to one.  But the excess demand they created caused a stagflation problem which good a decade to resolve. 

 

I don’t know what’s going to happen this time.  Fortunately for Powell, there are a lot of structural forces at work, pushing down inflation that didn’t exist in the 1970s.  And we have some charts in here that look at de-unionization, globalization, industrial robots, internet transparency and things like that.  I don’t think that Powell’s making an inflation mistake by easing, although he may be making an asset bubble mistake that we’ll find out about later.

 

I think the more important point is that whatever easing the Fed delivers is coming at a time of a pretty sharp slowdown of the global business cycle.  There’s a whole bunch of leading indicators that we look at on manufacturing, services, Japanese machine tool orders and things like that.  And they’re all pretty much sending the same signal which is that we’re expecting a period of much lower global GDP growth, lower US corporate profits, lower positive sales surprises from US companies and things like that.

 

On the first couple pages, we walk through that.  Also, show a slowdown in a real-time proxy for world trade volumes and things like that.  I don’t think the world is heading into recession because of the resilience of the service sector in most countries, and that should be enough to prevent the kind of equity market route we had last December.  But I do think in order to get another durable upswing in equities we need a pretty decisive positive upturn in some of these leading indicators.

 

It’s been really good year for risk-taking which has justified a continued normal portfolio investment approach. But after the July Fed meeting, I expect a period of flattish and volatile markets for a while because I think the market and economic benefits of further Fed easing are mostly exhausted.  But anyway, take a look.  And there are some interesting charts in here on some of the structural forces that are pushing down inflation over time that are giving the Feds some breathing room.

 

The second food fight that’s going on is a food fight that has two parts to it and it has to do with covenant light leverage loans.  The first part of the food fight is about the investors scrambling to buy them.  They now represent 80% of a growing 1.2 trillion-dollar US leverage loan market.

 

The more interesting food fight is between the people who think that there are a harbinger of doom for investors and those who don’t.  After looking at the facts and circumstances and background and after a decade of easy monetary policy and very aggressive loan underwriting, I think you can make a very strong argument that in the next recession, whenever that happens, and the Fed is certainly pushing it up by delaying it, by easing.  But whenever that next recession happens, I think we’re going to have materially lower loan recovery rates than we did last time.

 

If you are a loan investor if you don’t understand what maintenance tests are, most favored nation provisions, mandatory prepayments from asset sales, negative covenant restrictions, restricted payment clauses, EBITDA adjustments, collateral leakage, transfers to unrestricted subsidiaries, the ability to add senior or priority debt, lien dilution, etc.  If you don’t know what those things are you probably should because those are the protections which for many years existed to protect lenders from the things that loan issuers and their legal counsel would try to do to you. 

 

And do the aggressiveness of loan underwriting, which I think is a direct consequence of the Fed driving everybody crazy with zero policy rates, the leverage loan market has seen the broad set of collateral protections collapse for investors.  And we have a chart in here that gets into detail on a quantitative and qualitative assessment of the loan covenants overtime. 

 

And you can see just over the last seven years how sharply they’ve worsened from the perspective of leverage loan lenders.  There’s even a discussion in here about how even companies in default or which have experienced an event to default can now make restricted payments, pay junior debt that’s subordinated to you or incur new debt.  And so, that’s really a sign that some of the last bastions of creditor protections are fading away.

 

One of the things we talk about in detail here is this question of EBITDA add-backs.  If you look at anything related to leverage which is the level of debt divided by EBITDA which is a proxy for cash flow or you look at interest coverage which is your EBITDA cash flow proxy divided by interest.  A lot of those numbers don’t look so bad. 

 

The problem is the underlying EBITDA cash flow measure itself is being artificially boosted and flattered, in some cases pretty substantially, by these EBITDA add-backs which refers to the practice of companies adding back non-recurring expenses and assumed synergies and cost savings and things like that to earnings.

 

According to S&P around 30% of all deals use these add-backs and sometimes they increase your unadjusted EBITDA by 10% to 15% or more.  And Moody’s found some deals that allow these adjustments up to 20% to 30% of EBITDA and more.  So, the bottom line is that a lot of the statistics and measures that were designed to project investors are now being eroded through this decline in the quality of covenants.  There’s a long discussion in here about some of those things. 

 

Also, about how financial sponsors are behaving.  There are some examples of collateral stripping where, essentially, you have financial sponsors transferring collateral beyond the reach of senior creditors.  It’s happened in a few cases involving J.Crew and PetSmart and Neiman Marcus.  It hasn’t happened that much yet but due to the laxity of these restricted payments and other covenants that we walk through here this kind of thing could increase when and if the economy does turn.

 

All things considered I don’t think these trends argue for higher default rates.  I think default rates are going to be determined by the depth of whatever recession happens, and I do think the next recession is going to be a milder one than certainly that we had in 2008.  But these trends argue that for whatever defaults do take place we’re going to see much lower loan recovery. 

So, historically, let’s say loans were recovered at $0.70 on the $1.00, high yield bonds were recovered at $0.40.  It seems to us that the loan recoveries next time are going to be much closer to the high-yield recovery rates than the historical loan recovery rates.  And again, that is a byproduct of the broad-based deterioration in multiple different kinds of covenant protections for leverage loan lenders.

Those are the food fights of the week.  Thank you for listening and look forward to talking to you again later this summer.

 

FEMALE VOICE:  Michael Cembalest, Eye on the Market, offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renounced and provocative speakers.

 

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Click above to hear J.P. Morgan Eye on the Market's "Food Fight at the Fed, and in the Leveraged Loan Market" podcast episode and subscribe via Apple Podcasts or Google Play.

The food fight between the President and the Fed Chair rhyme with what happened in the 1970’s between Nixon and Arthur Burns. Rather than an inflationary hangover, too much easing risks expanding global valuations beyond sustainable levels. There’s another food fight worth watching: the one between leveraged loan issuers and buyers. Over the last few years, issuers have been winning this fight hands down. The broad erosion of loan covenants and the use of “cash flow add-backs” has reached unprecedented levels, arguing for materially lower loan recovery rights when the next recession one day arrives. A special Eye on the Market section takes a deep dive into the broad-based surrender of loan investors to issuers and their counsel.

Loan investors waving the white flag. Moody's loan covenant quality score is the weakest on record

Source: Moody's. Q4 2018.
Line chart: one line displaying Moody’s loan covenant quality score since 2012. The line is at its all-time high value, indicating weaker covenant quality.