Be wary of credit market complacency, says expert

Brian Carney believes the current state of the credit market is one that demands attention.

While it’s typically overshadowed by equity markets, it plays a crucial role in global finance because it’s where corporations, governments, and institutions secure funding. For investors, it represents a broad spectrum of opportunities and risks.

“The last crisis we had was COVID,” he says. “We had the central banks and the government step in. That stabilized things but we're now in a period where central banks have been normalizing… The further we get away from the last crisis, the more complacent market participants get,” says Carney, portfolio manager at Mawer Investment Management.

“They start to do something called ‘reaching for yield’. They’re looking for investments. They want to be in the market.”

When asked to describe the credit market, he simply says “it’s expensive.”

“Historically, the average spread that lower quality companies had to pay over and above US Treasuries or Government of Canada bonds to borrow was a little more than 5 per cent. Today, those lower quality companies are paying an average of about 3 per cent,” he explains.

That narrowing spread between high-yield bonds and government debt suggests that investors are accepting less compensation for risk than they have historically. It’s great for borrowers but less appealing for lenders, says Carney, because “the narrower the spread, from a lending point of view, the riskier it is.”

Carney makes the point that markets also tend to forget past crises. Institutional investors, who often prioritize capital preservation and steady income, could be underestimating the dangers lurking ahead.

Despite the warning signs, the market hasn’t yet reached a breaking point. However, history repeats itself and as previous market history suggests, credit markets operate in cycles, and downturns tend to arrive suddenly.

“Unfortunately, as you go through those phases: crisis, stabilization, normalization, the likely next phase is a crisis. We don't know what it's going to be, when it's going to be, but something always happens,” Carney says.

The shift to private credit

One of the biggest trends in recent years has been the rise of – or shift to - private credit. With the public high-yield market offering slim spreads, many institutions have turned to private lending as an alternative source of returns. But private credit comes with its own challenges.

“Private credit is high yield, without the protections of daily mark to market, credit ratings, transparency, and broad distribution. Liquidity is limited to non-existent.  Add to that many private credit funds employ leverage which can amplify returns in strong markets but magnifies the damage in down markets” he explains.

This illiquidity means that investors who commit capital to private credit funds can’t easily exit their positions. The additional spread, roughly 200 basis points above public high-yield bonds, might not be enough to justify the opacity and risk of these investments, highlights Carney.

The rapid growth of private credit has also drawn in a mix of experienced and inexperienced managers. While industry giants like Blackstone and Apollo have deep expertise, newer entrants may lack the same level of risk controls.

Carney says in some cases, outright fraud has tainted the space.

“Unfortunately, in Canada, we've seen outright fraud where people knowingly took money from retail investors to enrich themselves,” he notes.

The risks of complacency

Carney pointed to the shift in lending terms as another warning sign. In periods of market exuberance, borrowers gain the upper hand in negotiations, securing easier terms, higher leverage, and tighter spreads.

“Everything has swung in favour of the borrower,” he says. “If you get a bit of an economic downturn, I think a lot of companies are going to start to be in trouble,” warns Carney.

“In talking to people in the private credit markets, companies are executing deals with six times leverage and limited protections in the form of covenants at 500bps over the benchmark. That’s a lot of leverage and limited room for error,” he says.

Many of these loans are being extended to companies owned by private equity firms, which have an incentive to extract maximum value before potentially walking away.

“If you're a private equity firm, one of the ways to maximize your return is to take money out of those companies, lever them up, pay yourself a dividend, and, in the worst case, just hand it back to the lenders,” explains Carney.

One additional “wild card” Carney highlights is the deteriorating fiscal position of the US government. Treasury yields are the foundation upon which all credit markets are built, and any instability there could have wide-reaching consequences.

“There's a real question about the basic credit quality of the US government,” Carney says, pointing to the huge deficits and potential policies of the new Trump administration.

“They suggest that maybe those deficits are going to go higher,” he notes.

Given the risks, Carney believes institutional investors need to take a more dynamic approach to credit allocation by “actively managing their credit exposure through the cycle,” he asserts.

This means recognizing when risk premiums are too low and reducing exposure to high yield and private credit. Conversely, when spreads widen during periods of market distress, there may be opportunities to earn equity-like returns in the bond market, explains Carney.

“Managing based on where that that risk premium is, to me, makes a lot of sense.”

Ultimately, while timing the market is impossible, assessing whether investors are being adequately compensated for risk is crucial. Right now, though, Carney isn’t seeing many bargains. This is a market where the priority should be on capital preservation.