There is a lot of chatter about whether we are in another credit bubble. Whether there is so much corporate debt that we are going to experience another shock to the financial system. I just don’t see the evidence of that. We can get into details later, but let’s start by thinking about the psychology of the market and what it took to create a credit bubble last time and why we won’t see anything even remotely similar this time.
I have adapted Maslow’s Hierarchy of Needs to the Credit Markets. This model has actually behaved very well as it captures the psychological side of credit risk taking very well. Also, just like in Maslow’s original theory, I believe that the transition from one level to the next is key. That investors, just like people, tend to deal with the level they are at.
Physiological. This is the lowest level and represents a need for simple survival. Think back to the immediate aftermath of the financial crisis. Safety was in demand. Investors clamored for T-bills. It took incredibly large risk premiums to get investors to shift away from survival mode.
Safety. Once investors felt that survival was covered, they could get a little more aggressive. Safety is notch above bare survival. Agency debt, longer dated treasuries and investment grade corporations started to attract attention again. Very few investment grade corporations actually defaulted during the financial crisis, so investors started reaching up for IG, with a belief that these companies were stable and ‘safe’ and would stand the test of time.
Love/Belonging. I’m safe, now it is time to get a little bit more out of life. Let’s have some fun. High yield seems interesting. Emerging Markets could be the wave of the future. These ETFs are fun to trade and offer me access to fixed income asset classes that I couldn’t get access to before, at least not without costly redemption fees. HY, EM, etc. could not do well though until investors had satisfied their need for safety with IG.
Esteem. I’m good at this. I’m doing well, I’m making money. My decisions are good, but I need more. Let’s add a little bit of leverage. If I’m generating returns this good, imagine how well I can do with some leverage. Also, you know, I don’t really sell many assets so I can allocate to less liquid markets too. Structured products offer a lot of value too. They are a bit more complex at first, but once you do the work, they are surprisingly straightforward and offer some nice incremental yield. Plus, you can tell, a lot of investors out there just aren’t smart enough to do this. At least not yet.
Self-Actualization. I am a Credit Genius. More leverage? Bring it on! Less liquid? Bring it on! Triggers? Bring them on! Complexity? I haven’t met a product I can’t analyze and buy by the end of the week. The only thing slowing me down is that it is hard to trade and beat my chest at the same time! This is where we were in 2007!
We never got to Self-Actualization or Credit Genius stage this time around. We got close, but we didn’t get there. There are no subprime housing mortgages that have been tranched into asset backed securities, where those tranches were repackaged into new tranches (CDO squared or the famous ABX trades of The Big Short fame). SIV’s which allowed risk takers to add leverage at pre-determined margin rates that also had close-out triggers (effectively margin calls) don’t exist like they did then. No one would take on Leveraged Super Senior Risk (a trade where you take the safest part of a capital structure but leverage it a lot and then add in a mark to market unwind trigger).
It is my opinion that we never got to the Credit Genius stage, which means that while we may move lower on the pyramid, it will be a move that is slow and relatively uneventful – certainly nothing like the financial crisis.
I have an arrow pointing down. We are unwinding the Esteem part of the market’s Central Bank fueled chase for yield. We are hitting the next stage – which is why the bulk of the pain has been felt in High Yield (recently) and Emerging Markets (this summer). Yes, some investment grade names are under pressure, but they are the ones deemed by the market as being most susceptible to problems.
We may see credit spreads widen, but:
- The pain will be greatest in high yield, emerging markets and leveraged loans
- Any widening in investment grade as a whole will be slow. It will not be chaotic and will not have systemic risk implications.
- The Financial Crisis hit so quickly and so hard because products put on at the Credit Genius stage linked virtually all credit markets and had trigger mechanisms which caused forced selling to result in more forced selling which resulted in improbably large losses in an improbably short timeframe (and I was bearish at the time and my ‘roadmap to IG 200’ in early 2008 laid out how those interconnected trades could trigger such big losses). I just don’t see that being the case now.
We can get into more details, but in the meantime, you can refer to Don’t Be Afraid of the Big Bad BBB bonds or DEBT is a 4-Letter Word – For Now. They offer some detailed reasons why the macro tourists who are pointing at IG credit, particularly BBB bonds, are just wrong.