Late cycle, long cycle, mid-cycle, unicycle

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Justin H. Bourgette, CFAPortfolio Manager, Global Income Team and Jeffrey D. MuellerPortfolio Manager, High Yield Team

      London and Boston - Every time we meet a client, prospect or journalist, they want to ask us about one thing: the credit cycle, how long it has gone on, and when it is going to end.

      This cycle is certainly long, but that is not to say that the end is imminent. We try to cut through the noise and see what the available data is telling us.

      About those fundamentals

      Larry Bird, one of Boston's great sports heroes, had a simple approach to the beautiful game of basketball. He built his success by focusing on solid fundamentals. The Eaton Vance Multi-Asset Credit team's investment approach is similarly based on a pursuit of excellent fundamentals.

      Bird shot free throws and lay-ups, while we assess how likely our investments are to pay us our coupon on time, every time. Sounds like the same thing, right?

      Two primary things we focus on across our core allocations in leveraged credit are:

      1. How many times over a company's earnings cover the coupons it needs to pay on its outstanding bonds (i.e. interest coverage)

      2. The level of debt a company carries on its balance sheet relative to the level of earnings it generates (i.e. leverage)

      The first lets us assess a company's ability to service its debt, and the latter is often a measure of how aggressive a company is being.

      What are the markets telling us?

      Against the backdrop of strong corporate earnings, the fundamental picture remains robust in the U.S. loan and bond markets, with signs of continued strengthening. Q1 2019 saw another decrease in leverage and an increase in interest coverage, both continuing multi-quarter trends of improvement.

      Europe has reported solid interest coverage levels (largely driven by lower borrowing costs) but this has been overshadowed by a steady increase in the average leverage of borrowers in this market.

      Signs of continued divergence but high-yield fundamentals remain solid

      Blog Image MAC Divergence May 6

      Source: Morgan Stanley. Data as of 12/31/2018.

      "Late-cycle" behavior is typically characterized by increasing leverage and falling interest coverage as companies take more risk to try and generate returns, and getting themselves into serious difficulty when the cycle turns. Think about technology, media and telecommunications companies in the early 2000s as a prime example.

      The current data is not quite painting as negative a picture as the media headlines would have investors believe.

      Is any of this information investable?

      We recently blogged about the European high-yield corporate bond markets. Despite the slightly weakening fundamental picture, we believe the value opportunity is still compelling. In the chart below, we do some analysis to facilitate a like-for-like comparison of the credit spreads available in the U.S. high-yield corporate bond markets (U.S.-dollar denominated) and the European high-yield corporate bond markets (euro and sterling denominated). The analysis involves stripping out the energy sector from the U.S., as this is only a small portion of the European benchmark. We also re-weight the indices to have the same average credit rating and duration profile.

      Relative value continues to favor European high-yield bonds

      Blog Image MAC Relative May 6

      Source: Morgan Stanley. As of 03/31/2019. US and European High Yield Spread data is option-adjusted, ratings-normalized, and excludes energy and commodities. "bps" = basis point (one hundredth of one percent).

      You can see that outside of three instances of extreme market stress (dot-com bubble, global financial crisis and Eurozone sovereign debt crisis), the European markets are trading as wide (from a credit spread perspective) as they ever have to the U.S. markets.

      We do not believe that this is warranted, and are confident that the fundamental picture remains supportive enough to take a meaningful position in these markets.

      Bottom line: We are not saying that we're early cycle, but we're also not necessarily saying that the cycle is about to end. Periods of volatility may show themselves across leveraged credit markets, as they did in Q4 2018. But if you focus on the fundamentals and avoiding those defaults, we think you can make money from leveraged credit markets over the long term. We suggest looking past the noise in the market about "late-cycle" and focusing on what the available data is telling you.