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Why We Are Not in a Credit Bubble

September 20, 2012

While I am not bearish, I would be cautious about plowing into new positions. And, we saw some of that caution on Friday as sellers showed up in many of the strong momentum stocks.
-Sean Slein, co-portfolio manager, First Eagle

With yields near all-time lows, and high yield issuance near an all-time high, are we approaching a credit bubble similar to the one that preceded the 2008 financial crisis?

No, says Sean Slein, co-portfolio manager of the First Eagle High Yield Fund. Consider:

  • Credit conditions remain positive for the asset class with current spreads being compensatory relative to risk, embedding a 4-5% default rate versus the LTM default rate as of July of 2.5%.
  • Primary issuance quality remains high, as companies engage in refinancing activity to strengthen their financial position
  • The Federal Reserve remains accommodative
  • Spreads between the BB and B credit tiers remain near 200 bps (which is the historical average)
  • Companies continue to cut costs and deleverage, as opposed to engaging in leveraging activity
  • Leveraged buyout activity hasn't hit pre-crisis bubble levels, resulting in better deal quality and structure
  • Covenant quality is adequate, although gradually eroding (as expected).

This is a far cry from the risky environment that defined the 2005-2007 timeframe.  

While Slein says the credit cycle is currently in a phase of stability, he believes that the high yield market will gradually misprice risk, though that is most likely a few years away.  High yield should perform well in a positive growth environment, albeit a slow one, because it has the spread cushion to withstand a parallel shift higher in the yield curve; it can also provide an income cushion via the coupon in a low yield environment.