As the Fed’s first interest rate hike looms, corporate bonds are coming under more scrutiny. Issuance of corporate bonds has exploded, thanks to ultra-low interest rates provided by central banks. With Treasury yields set to rise, corporate bonds will have offer greater returns in order to justify their risk. The question is, can these companies handle this huge debt load?
Not Your Father’s Safe Haven
Thanks to quantitative easing (QE) by the Fed, interest rates have been artificially low since 2009. This has had two effects on the business sector. First, it makes borrowing money very attractive. Issuance of corporate bonds hit a new record of $3.5 trillion last year.
Secondly, near-zero yields on government debt allows corporate bonds to offer a low yield but still remain more attractive than Treasuries. Even pension funds have been driven into corporate bonds by near-zero Treasury yields. This has greatly increased exposure to corporate debt for millions of people, without them even knowing it.
This torrent of new debt has mainly financed stock buybacks, mergers, and acquisitions, instead of capital improvements. This has driven corporate leverage to the highest level in ten years; more than double the level before the Lehman Brothers collapse. Debt to earnings ratios are also at the highest level since the start of the financial crisis.
This over-indulgence in debt is attracting the attention of a growing number of investors, leery of buying bonds of a company that may have trouble paying on them.
The Chase For Yield
Why have investors flocked to the bonds of over-leveraged corporations in the first place? In short, a chase for yield.
Treasuries no longer pay enough for fixed income funds to meet their disbursement goals. This has forced them into the corporate bond market. Retirees are forced either into stocks or junk bonds, as Treasuries fail to meet their financial needs.
Fixed income investors in Europe have it even worse than those in the United States. Not only are safe German bonds selling at negative interest, nearly bankrupt Italy is selling short-term debt at negative yields. Which would you rather do: pay Italy for the opportunity to lend it money, or by an investment grade corporate bond for 2% yield or more?
Both large and small investors are operating under the assumption that investment grade bonds are as safe as they have been in the past. But corporate bond risks are growing. Many blue chip companies are just one crisis away from being downgraded by ratings agencies,
Two recent examples of giant companies suddenly finding themselves in trouble are Volkswagen and Glencore. VW has been dealt a huge blow over emissions test fraud, putting sales and revenue in doubt. Glencore has been hammered by falling commodity prices. This raises doubts about its ability to service the billions in debt it accrued from acquisitions.
Being downgraded mean that ratings agencies have greater doubts about the company’s ability to meet its debt obligations. This causes the price of their existing bonds to fall, as they are now seen as more risky. It also means that the company will have to offer higher yields on new debt. This increases debt load, which again calls into doubt their ability to pay.
Another problem that is gaining attention is credit risk on corporate debt. When the Fed starts raising rates, the yield on Treasuries will rise. This reduces the credit spread (the difference in government bond yields and corporate bond yields.) As Treasury yields rise, new corporate bond yields will have to rise. Existing bonds will drop in market value, to bring the effective yield to present levels.
Falling credit spreads at the same time borrowing costs increase is set to put the squeeze on many over-leveraged companies.
Corporate Bond Liquidity (or Lack Thereof)
Part of the new regulations on the financial sector since the crisis has limited the amount of corporate debt investment banks can hold. They are also restricted in buying bonds from their clients and holding them on the books until they can be resold. This has reduced short-term liquidity in the corporate bond market. A perhaps bigger factor is expectations by institutional investors that the credit squeeze mentioned above is about to happen. When there are so few buyers and sellers, only the first ones out the door during a bond rout will find a buyer.
Risk of Contagion from Emerging Markets
Both corporations and governments in emerging markets have loaded up on debt during the era of easy money. Emerging market corporate debt as quadrupled to $18 trillion in the last decade. Almost half of that belongs to China, where corporate bond defaults are spreading to local governments. As China’s economy slows down, these defaults will spread to the countries that supply them with raw materials.
Time For A Turn In The Credit Cycle
The expected rate hike in the US next month will signal a turn in the credit cycle. Investors will start scrutinizing the fundamentals behind companies issuing debt, and stop blindly chasing yield. A tightening of credit terms will push companies into bankruptcy. Defaults are expected to rise, as companies that issued high-yield bonds are unable to roll them over, and unable to service existing debt.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.