TSS Episode 142: Robert Cohen on Credit Selection and the Coming Default Cycle

Robert Cohen, head of DoubleLine’s Global Developed Credit team, discusses navigating the waters of investment grade and high yield corporate bonds and leveraged loans as these markets enter the late stage of the economic and credit cycles. He speaks June 9, 2023, with DoubleLine’s Jeffrey Sherman and Samuel Lau.

“We’re in a period, probably the greatest period in the last decade, where credit selection matters,” Mr. Cohen tells Messrs. Sherman and Lau (25:00). “It really hasn’t mattered for a long time. We’ve been in an environment where beta trades worked. So you liked an asset class, you liked high yield or you liked emerging markets, or you’re putting on these beta trades where you’re just allocating to a sector. Now we’re seeing great dispersion amongst the constituents of these asset classes, and we’re seeing that the dispersion of managers is widening because it’s all about credit selection.”

For corporate credit, Mr. Cohen defines a late cycle (3:01) as an environment in which “companies try to defend their balance sheet, so instead of raising money and borrowing more, they try to pay down their debt. That tends to be when credit conditions get tight, lenders are more strict or more discerning about the companies that they lend to. You often see credit metrics deteriorating in that environment.” These phenomena are underway, he says, amid a raft of warning signs portending recession such as the inverted Treasury yield curve and a negative year-over-year change in the Leading Economic Index. Credit markets are not pricing for a recession, but Mr. Cohen thinks the next one is coming in early 2024 if not by the end of 2023.

The next default cycle (5:47) has yet to begin in below-investment-grade corporate credit, although Mr. Cohen expects it to come with or without recession. With respect to investment grade corporates, rather than looking for the rare default, Cohen is on watch for changes in new issuance, leverage and risk-taking “as opposed to companies that are defending their balance sheets, borrowing less, paying down debt.”

The term “leveraged credit” (7:29) encompasses both high yield bonds (fixed rate) and bank debt (floating rate), both of which are below investment grade. “They work kind of in tandem with each other. There are often cases where borrowers will tap both markets for a senior secured term loan and an unsecured high yield bond,” he says. “Lately, really since the pandemic in 2020, you’re seeing borrowers tap the high yield market and loan market for both a secured loan and a secured bond.”

While leveraged credit defaults peaked at around 10% in the wake of the Great Financial Crisis (8:40), Mr. Cohen expects a lower peak in defaults if the next recession is less severe, but recovery rates on defaulted bank loans will be worse The reason? “In a prior cycle, maybe bank loans would recover 70% or 80% of their initial par value” post-default, he says. Due to a decadelong deterioration in protections for secured senior lenders, he expects “recoveries closer to 50% or even lower.” In contrast, high yield bonds (10:21), Mr. Cohen notes, appear in stronger shape than at anytime before. He cites growth in the BB share of the sector and the highest percentage of secured bonds in the sector’s history. “While the loan market has been getting worse in credit quality, the high yield market has actually been getting better in credit quality.”

The canaries in the leveraged-finance coal mine are B- bank loans (12:50), Mr. Cohen says. These represent 25% of outstanding bank debt. In the wake of 500 basis points added to the debt service on these floating-rate instruments by Federal Reserve rate hikes, Mr. Cohen says B- loans on average are at best free cash flow neutral. “So they’re kind of a ticking time bomb. If they’re free cash flow negative, they’re going to run out of cash soon enough. They’re also not refinanceable with today’s tight credit markets.” Overlevered companies “running into a maturity or running thin on cash” have some options. “We are seeing some equity sponsors in the LBO market put more capital into the deal and work with lenders to extend the runway.”

Recession or no, and in the event of recession, the Fed resuming quantitative easing (QE), Mr. Cohen (16:07) sees many below-investment-grade companies on track to default this cycle. He also sees scenarios under which the Fed cannot effectively intervene to reverse the next downcycle, leading to a long, slow bleed amid tight credit markets rather than the V-shaped collapse-rebound action seen in the recent past. Persistent inflation, he adds (18:56), could disappoint those who are counting on the Fed put. Inflation could “trough this year around 3% and then start ticking back up. If that view is right and inflation starts to tick back up in 2024, how’s the Fed going to really cut? Maybe they cut a little bit, but the idea that they’re going to go back to the old QE playbook, supporting capital markets while inflation is running more like 4%, that just doesn’t seem realistic to me.”

In terms of allocating to high yield bonds (20:50), given the likelihood of “a recession on the horizon, I think you have to pay attention to spreads,” Mr. Cohen says. High yield credit spreads have been trading in a range between 400 and 580 basis points. “I think trading that range has worked. So when you get to low 400s, I think you’re supposed to be trimming high yield. When it gets north of 500, I think you’re supposed to be buying, because once you get north of 500, you start to get compensated for the potential for a recession.” The loan market doesn’t trade that way. For loans, Mr. Cohen favors the BB cohort. “The default expectation for the BB cohort is less than 1%. So if you have any decent credit selection, you’re going to be able to avoid the stress if there’s a recession.”

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