May 23, 2019 – Financial system stress comprises an important set of variables that we continually track. While not always indicative of where or when the next recession will start, we do believe it helps us find pockets of the market that may be more prone to breaking down. Importantly, the Federal Reserve now produces a biannual study, named the “Financial Stability Report,” and its second issue was released two weeks ago. The stated goals of the study are to assess the resilience of the U.S. financial system:
A stable financial system, when hit by adverse events, or “shocks,” continues to meet the demands of households and businesses for financial services, such as credit provision and payment services. Shocks, such as sudden changes to financial or economic conditions, are typically surprises and are inherently difficult to predict. Vulnerabilities tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress.
Significantly, the objective of the report is not to be predictive, but to assess the financial system and any risks. The report focuses on four areas of potential vulnerability within the financial system:
- Asset valuations across real estate, equities, and debt markets
- Borrowing levels and trends across corporations and the U.S. consumer
- Leverage within the financial system
- Funding risks (e.g., asset/liability mismatch)
This is not to claim that vulnerabilities will cause a recession, but rather that they can amplify downside potential in certain portions of the financial system that present higher risk.
One topic that received additional attention in this most recent report was a discussion about potential risks from elevated business debt, with the credit market and leveraged loans receiving specific observations. As a reminder, leveraged loans (also known as bank loans or floating rate loans) are a close cousin of the high-yield bond market as they both represent below-investment-grade credit risk. The Fed highlighted that covenant quality for leveraged loans has deteriorated meaningfully over the past few years as issuers have received greater flexibility due to robust investor demand. Covenants are terms and conditions within the legal documents that require maintenance of certain financial ratios and/or prevent certain activities (e.g., a firm taking on more debt). In an earlier blog post, we had commented on this persistent trend, which may increase downside risk in the event of an economic downturn or other shock.
Additionally, the report highlights a greater proportion of the new issuance in leveraged loans has been made to firms with higher debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios which brings heightened risk but again indicates robust market appetite and is reflective of the healthy economy.
Lastly, the report points out that there has been a meaningful increase in the portion of the investment-grade credit universe that is rated at the lowest investment-grade rating of BBB/Baa. As we pointed out in our 2019 Capital Markets Forecast, this trend could persist for years and is reflective of the healthy economy, low interest rates, and low default rates. To reinforce this point, we have included a chart of high-yield spreads, which are broadly indicative of market appetite for riskier credit exposure. Higher spreads would indicate investors believe risk is higher and thus need more yield to compensate for the risk. As one can see, despite the market selloff late in 2018, spreads have largely retraced those losses and are now generally back to levels realized over most of 2017 and 2018.
High-yield option adjusted spread
Sources: Federal Reserve Economic Data, ICE BofAML US High Yield Master II Option-Adjusted Spread, Percent, Daily, Not Seasonally Adjusted.
Data as of April 30, 2019
Both Wilmington Trust and the Federal Reserve are closely monitoring a steady increase in the vulnerability of the financial system, due in part to trends within the credit markets. Credit markets are broadly indicating that there are no impending signs of recession, but we have had zero exposure to leveraged loans for some time. Additionally, while we believe the U.S. economy is healthy, we have recently trimmed our U.S. Large-Cap Equities exposure to reduce risk as a result of the China trade situation.
 Board of Governors of the Federal Reserve System, “Financial Stability Report,” May 2019.
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