Corporate spreads are past the sweet spot, financial engineering is on the rise:
We’ve seen and studied enough corporate credit cycles to understand the normal sequence of events. You can largely break it down into three stages. In the first stage spreads are high, corporate financial conditions are good and improving, and stimulative monetary policies support an expansion of liquidity which finds its way into the highest-quality credits at attractive prices. Over time the money flows from higher- to lower-quality credits and spreads across industries and credit ratings fall. This brings you to the second stage, when corporate financial conditions are still good, but spreads are tight, fully discounting these conditions. Typically, at this stage, macroeconomic conditions allow for accommodative monetary policies which sustain the flow of liquidity, producing continued positive but lower excess returns on corporates, encouraging investors and traders to take on leverage to achieve higher return targets, further tightening spreads. During this stage is when you start to see credit standards fall and creative financial engineering pick up. That is roughly were we are now, which is still a favorable environment, but increasingly dependent on accommodative monetary policy, and therefore increasingly vulnerable to a tightening of liquidity. This stage transitions to stage three, where leverage builds until a tightening of monetary policy weakens profitability and cash flow at a time when debt and debt service are high, producing credit problems and a widening of spreads. We are not there yet. The following charts show tight spreads and low but rising debts, conditions that are roughly similar to the mid-2000s.