A $9 Trillion Corporate Debt Bomb Is ‘Bubbling’ In The Us Economy (#GotBitcoin?)
At first glance, it looks like a $9 trillion time bomb is ready to detonate, a corporate debt load that has escalated thanks to easy borrowing terms and a seemingly endless thirst from investors. A $9 Trillion Corporate Debt Bomb Is ‘Bubbling’ In The Us Economy (#GotBitcoin?)
Companies Are Carrying A $9 Trillion Debt Load, Posing A Potential Threat Should Rates Continue To Rise And The Economy Weaken.
Most Wall Street Bond Experts Think The Issue Is Contained For The Next 12 To 18 Months, Though One Says The Market’s “Angst” Is “Not Misplaced.”
A Principal Worry Is Over Companies Teetering Between Investment Grade And Junk That Could Cause Market Trouble Should Their Standing Deteriorate.
On Wall Street, though, hopes are fairly high that it’s a manageable problem, at least for the next year or two.
The resolution is critical for financial markets under fire. Stocks are floundering, credit spreads are blowing out and concern is building that a combination of higher interest rates on all that debt will begin to weigh meaningfully on corporate profit margins.
“There is angst in the marketplace. It’s not misplaced at all,” said Michael Temple, director of credit research at asset manager Amundi Pioneer. “But are we at that moment where this thing blows sky high? I would think that we’re not there yet. That’s not to say that we don’t get there at some point over the next 12 to 18 months as rates continue to move higher.”
Essentially, the situation can break in two ways: a good-news case where companies can manage their debt as the economy stabilizes and interest rates stay in check, and the other where the economy decelerates, rates keep heading up and it’s no longer so easy to keep rolling that debt over.
There’s one worrying trend where companies on the edge of the investment-grade universe lose their standing and turn into high-yield or junk, sending rates — and defaults — significantly higher. And there’s a more positive case where the U.S. continues to outperform the rest of the world and corporate debt problems are limited to overseas and specific companies that aren’t systemically important.
“The answer hinges on how long we have until the credit cycle turns, how long we have until interest rates have gotten to the point where they start to snuff out economic activity,” Temple said. “If we were of the opinion that interest rates are already too high for the economy to stand and the recession was going to happen sometime next year, then I would say we’ve got a real big problem here.”
As things stand, though, he thinks conditions are still favorable for the corporate credit market.
“In our view, economic activity will probably moderate next year, but at a very high level,” he said. “That’s not enough to cause the chaos that I just described.”
Nearly doubling the debt
Over the past decade, companies have taken advantage of low rates both to grow their businesses and reward shareholders.
Total corporate debt has swelled from nearly $4.9 trillion in 2007 as the Great Recession was just starting to break out to nearly $9.1 trillion halfway through 2018, quietly surging 86 percent, according to Securities Industry and Financial Markets Association data. Other than a few hiccups and some fairly substantial turbulence in the energy sector in late-2015 and 2016, the market has performed well.
In fact, Fitch Ratings forecasts bond defaults for 2019 at the lowest since 2013, with leveraged loans at the lowest since 2011.
Such high debt levels are “certainly something to take notice of,” said Eric Rosenthal, Fitch’s senior director of U.S. leveraged finance. “In terms of the systemic risk, at the moment it’s not there.”
One reason markets worry about debt is that there’s not as much cash around to cover it. The cash-to-debt ratio for corporate borrowers fell to 12 percent in 2017, the lowest ever.
Still, there’s reason for optimism.
Fitch estimates that new investment grade issuance was $531 billion through the third quarter, a more than 15 percent drop from the same period a year ago. High-yield issuance also has declined to $138 billion, a 32 percent drop from 2017.
The 2017 tax breaks also appear to be helping. Companies saw their nominal tax rates reduced from 35 percent to 21 percent and apparently are using a large chunk of the windfall to knock off some debt.
Since the tax cut took effect, the top 100 corporate nonfinancial companies have spent $72 billion of new cash flows to debt payments, a bit behind the $81 billion that went to shareholder returns through buybacks and dividends, according to Moody’s Investors Service.
“Companies are spending a much larger percentage of incremental dollars on debt reduction,” the ratings agency said in a report. “What we see when we look at the annual net borrowing activity is a big swing from issuers changing from a net borrower each year pre-tax overhaul to a net-payer of debt post-tax overhaul.”
Investors Still Willing To Buy
For the debt that is issued, investor demand remains strong if beginning to wane a bit.
One measure of how willingly the market is snapping up bonds, particularly those lower in quality, is through covenant quality, or the amount of protections being demanded in case of default. Moody’s reports that its Covenant Quality Indicator has held at its lowest level of classification for 18 straight months and is just off the record set in August 2015.
At the same time, that could be a trouble sign as balance sheet strength becomes more important.
“The high-yield sector, every way we look at it, just seems pretty overvalued and not worth the amount of risk that you’re taking,” said George Rusnak, co-head of global fixed income for the Wells Fargo Investment Institute. “What we’re seeing now is some spreads widening, which will be more impactful on high yield. We could see triple-B credits, some of them, move from investment grade to high yield.”
That slide from low investment grade to junk is one of things that scares markets. General Electric is the highest-profile case to have that potential, though company officials insist they are doing everything they can to make sure that doesn’t happen.
Should a company that big slide, it would reshape the high-yield market. Investors would be counted on to snap up those bonds, but could demand even higher yields to do so.
“It sets up for a liquidity trap. You get an underappreciated risk that becomes a catalyst,” Rusnak said. “The second wave of buyers that are holding high yield realize they have more risk than they thought … and it’s kind of a downward spiral.”
Well Fargo itself is retreating from the space, with a neutral position on investment grade corporates and an unfavorable outlook on high yield.
“There is a lot of leverage. You could argue they took what the market gave them, to take on the leverage at lower interest rates,” Rusnak said. “The question is will they be able to sustain. In a lot of cases they will, but there will be some bubbling up of challenges.”
The Leveraged Loan Threat
One of those other challenges also comes from the leveraged loan market, a growth area that now tops high yield in total issuance with $1.3 trillion.
Sen. Elizabeth Warren spoke publicly about the threat in a recent public hearing, with the Massachusetts Democrat warning Randal Quarles, the Federal Reserve’s vice chair of supervision for the banking industry, that leveraged loans pose an economic threat on scale with subprime loans from a decade ago.
“The Fed dropped the ball before the 2008 crisis by ignoring the risks in the subprime mortgage market,” Warren said.
Simon Macadam, global economist at Capital Economics, also said leveraged loans, which generally are issued to lower-quality borrowers that already have a substantial debt load on their balance sheets, pose a danger.
“The main concern is a drop in lending standards,” Macadam said in a note to clients. “In the US, the share of leveraged loans with no requirements for borrowers to meet regular financial tests, such as maximum leverage and minimum interest coverage ratios, has risen from around a quarter in 2007 to a record high of 80% today.”
However, Macadam said that “for the time being” there are “at least three sources of comfort” for why the danger won’t become systemic: “manageable” corporate debt loads, stronger bank capital, and an expected tempering of interest rate rises. Capital has an out-of-consensus forecast that the Fed will begin reducing rates into 2020 as the economy weakens.
Currently, the Fed is expected to approve a rate hike in December and has forecast three more in 2019.
Company By Company
Indeed, fixed income strategists who spoke to CNBC were almost unanimous in their belief that problems with corporate debt will be far more company-specific than systemic.
“From a higher-level 30,000 feet, most U.S. corporates are in pretty good shape,” said Yvette Klevan, portfolio manager for global fixed income at Lazard Asset Management. “The economy is still very strong. Tax reforms are beneficial. Looking into next year, overall debt servicing should be very stable and not problematic. We see a lot of opportunities in the market.”
The current climate is likely more conducive to active management, or selecting individual issues, rather than following broad indexes, Klevan said. Passive taxable bond funds currently hold more than $1 trillion in total assets.
The current climate shows “how important it is to do your homework,” she added. “From my perspective, it’s key to have diversification.”
Lazard has found value in “green bonds,” which focus on companies that invest in environmentally sustainable ways.
That’s not to say there isn’t danger out there, but Klevan does not see it in a macro sense for the U.S.
“We all have to be very mindful of this buildup of debt everywhere, over the past especially five to seven years,” she said. “Overall, and I say this probably from a sovereign standpoint, debt can be a tax on growth. So that’s going to have a big impact in the medium term on a lot of countries.”
Europe’s Cheap Debt Draws Record Borrowing by U.S. Companies
Medtronic, Coca-Cola and IBM among the businesses that raised an unprecedented $113.5 billion from so-called reverse Yankees in 2019.
U.S. blue-chip companies raised an unprecedented sum in eurozone debt markets last year, reflecting the region’s ultralow interest rates and global investors’ thirst for securities issued by highly rated companies.
Coca-Cola Co. KO 0.21% and International Business Machines Corp. were among the companies that raised a total of €101.7 billion ($113.5 billion)—a record for nonfinancial company debt—by selling corporate bonds denominated in euros in the past year, according to data from Dealogic. That was more than double the €42.2 billion raised the previous year from selling such debt, known as reverse Yankee bonds.
Capital markets in Europe have gained growing attention from corporate borrowers since 2012, as central banks in the region pushed a number of key benchmark rates to subzero levels. That has driven down borrowing costs, while leaving fixed-income investors looking for alternatives to the razor-thin returns offered by government bonds.
The average yield on euro-denominated nonfinancial corporate debt is currently 2.38 percentage points lower than on the U.S.-dollar equivalent, weighted across maturities, according to data from ICE BofAML indexes.
The low yields and strong investor appetite helped fuel a 38% increase in the sale of euro-denominated bonds, to €450 billion in 2019, by companies that aren’t banks, insurers or other types of financial firms, according to Dealogic. U.S. businesses dominated the market, eclipsing Germany to make up nearly a quarter of the total, as some of the largest and most creditworthy American companies took advantage of the attractive yields to tap a fresh group of investors while paring their debt costs.
Investors’ interest has escalated further since the European Central Bank resumed bond repurchases in November, snatching up even more of the debt on its approved list and leaving investors looking to other corners of the market for fresh opportunities.
“You even have some companies that have no European operations still financing in euros and hedging it back,’’ said Thomas Ross, a fixed-income portfolio manager at Janus Henderson in London. “They’re both benefiting from the ECB and the demand for yield from investors globally.”
Even after factoring in the expense of converting the euros to dollars, there’s a cost advantage of about 15 basis points on benchmark 10-year bonds for the issuers, according to Thibaut Cuilliere, head of real asset research and a credit strategist at French bank Natixis. He estimates that is likely to widen to 25 basis points on average by the end of the year.
In the first two weeks of 2020, U.S. companies including food manufacturer General Mills Inc. raised €1.14 billion from reverse Yankees, according to data from Dealogic. General Mills, whose brands include Lucky Charms and Pillsbury, tapped the market for €600 million with a 0.450%-coupon note maturing in 2026.
While American companies in the past have used reverse Yankee bonds to fund European operations or the acquisition of companies in the region, more and more businesses on both sides of the Atlantic are now simply taking the opportunity to refinance their existing debt at cheaper levels, and for longer periods. The average maturity for reverse Yankee bonds in 2019 was 8.84 years, according to Dealogic.
Redemptions—or early repayments on debt—will climb 21% to €260 billion in the euro-denominated corporate bond market this year, according to Natixis.
U.S. companies with investment-grade ratings, rather than high-yield issuers, have benefited the most from the imbalance created by the ECB’s bond-buying program, which focuses on lower-risk securities. Companies with lower ratings also tend to be smaller and less known internationally, hindering their ability to get favorable treatment from European investors.
“If you’re a high-yield name in the U.S., you’d have to spend a lot of time trying to educate the investor base in Europe if you come over here,’’ said Roger Appleyard, head of credit sector strategy at RBC Capital Markets. “Even in those circumstances, you might not get cheaper funding than in the States.”
The European corporate-bond market is likely to see a slowdown this year following a pause in mergers and acquisitions during 2019, and as big cash piles deter local businesses from fundraising, according to Mr. Cuilliere. Still, reverse Yankee bonds will continue to dominate the market, he forecast.
“Given the high levels of liquidity provided by the central bank, it means that the spread will stay low for a longer period of time,’’ Janus Henderson’s Mr. Ross said.
Struggling Corporate Borrowers Raise Risks In Loan Funds
Chicago’s Portillo’s is one of many indebted companies hit by the pandemic that may cause losses for investors.
The future of a $700 billion market for risky corporate debt rests on companies like Portillo’s Hot Dogs, Chicago’s famous fast-food chain.
Portillo’s owed about $550 million in loans when it stopped serving inside its 62 restaurants in March. It was suddenly at risk of going bust and credit-ratings firms quickly slashed grades on its borrowings.
The company’s loans sit on the books of dozens of collateralized debt obligations, which buy up risky corporate debt and package it into securities. With sales way down, many of those companies have gone from just being risky to teetering on the brink of bankruptcy. Retailers like Neiman Marcus and J.Crew Group Inc. have already tipped over the edge.
The stress is testing the CLO market, which has allowed companies to rack up debt, often to fund private-equity buyouts.
So far, only modest cracks have appeared in CLOs, but they threaten to cut off a cheap source of corporate credit and cause losses for investors who stretched for a bit of extra return.
CLOs have become the dominant force in high-risk lending, buying about 60% of new leveraged loans in the past few years. In total, CLOs own about half the U.S. market, according to LCD, S&P Global’s loan research arm.
For investors in CLOs, the downgrades and defaults have caused prices to fall, potentially leading to losses on securities that were supposed to be as safe as government bonds. CLOs create these securities the same way bankers turned risky mortgages into triple-A bonds before the financial crisis. They slice up pools of loans so that most of the risk is squeezed into a few securities that are sold to investors who are willing to take it on in exchange for high returns.
The remainder, about 65% of a CLO’s debt, is sold as triple-A bonds. Now protected by a cushion against losses, these bonds are considered safe but with a yield that is attractive for banks, which buy about half of the bonds, insurance companies and pension funds.
Two of the biggest individual holders of triple-A bonds are Japanese farmers bank, Norinchukin, which owns about $75 billion worth, and Wells Fargo & Co, which owns about $30 billion worth. John Shrewsberry, Wells’s chief financial officer, said the bank had seen “no meaningful signs of stress” among these holdings, on the bank’s first-quarter earnings call.
The safe CLO bonds didn’t default in the financial crisis and are unlikely to suffer this time, people in the industry say.
“Triple-A CLOs can withstand defaults to almost the entire portfolio of underlying loans,” said Sid Chhabra, head of structured credit and CLO management at BlueBay Asset Management. The reason is because even if loans default, historically investors have recovered 60 cents on the dollar. Combined with the cushion provided by the riskier pieces of the CLO, the amount left over after a default would protect investors in the safe securities.
There are signs that CLOs could perform worse than they did in the past. The pandemic-caused downturn came after a historic boom in corporate borrowing, much of it driven by private-equity buyouts. In 2008, private-equity firms owned about 4,700 companies, roughly the same number as companies listed on stock exchanges. A decade later there were a couple of hundred fewer public companies, while private equity owned more than 7,700, according to the Milken Institute.
With the growth in buyouts, the U.S. market for junk-rated leveraged loans more than doubled in size since 2008, to more $1.2 trillion, according to S&P’s LCD. The booming CLO and loan markets of recent years allowed borrowers to get larger loans with looser terms. That meant credit quality was already worse than in 2008 before the coronavirus hit.
At the start of 2008, about 9% of loans in the main U.S. loan index, the S&P/LSTA, received relatively low ratings of single-B-minus and less than 2% were triple-C or below, according to LCD. At the end of January this year, single-B-minus loans made up 20% of the index and triple-C loans nearly 6%.
Since then there have been more than 200 ratings downgrades for loans, the most rapid wave ever seen in the market, according to investors and analysts. Now about 11% of the U.S. index is rated at the troublesome triple-C and worse level, close to the 11.5% peak hit in early 2009, according to LCD.
UBS analysts forecast that triple-C rated loans will make up 33% of the market in their most optimistic view, which is based on U.S. economic activity being largely back to normal by the end of June.
Portillo’s, which has served hot dogs, Italian beef sandwiches and chocolate cake to generations of Chicagoans, was cut into the triple-C category by ratings firm Moody’s Corp. in late March. The restaurant chain owes about $550 million after a 2014 leveraged buyout by Boston-based Berkshire Partners. In 2019, its debt was about 7.5 times its earnings, according to Moody’s, which predicted that would increase to 9 times.
Close to 100 CLOs hold pieces of Portillo’s debt, according to loan tracker Trepp CLO. So when companies like Portillo’s suffer downgrades, that can cause a ripple effect for the managers.
CLOs have a limit on the amount of triple-C debt they can own, typically up to 7.5% of their portfolios. This effectively limits how the CLOs operate and can make it harder for them to buy new loans. Managers can guard against this by selling loans that are facing problems and buying better ones.
Portillo’s debt rebounded from the low 80s to above 90 cents on the dollar after Moody’s March downgrade. Chief Executive Michael Osanloo credits the rebound to a quick pivot toward serving drive-through customers who have flocked to the restaurant chain.
“We generate enough cash flow to cover all of our debt payments with no problem,” Mr. Osanloo said.
However, it isn’t easy for CLOs to take advantage of those buying opportunities. With industries like travel, hotels and retail all suffering, investors are trying to sell the same loans, driving prices down, while buying better ones.
“Everyone’s competing for the same ones and they’re getting bid up,” said Michael Herzig, head of business development for First Eagle Alternative Credit, which runs 25 CLOs with about $13 billion in assets.
With trading loans hard, CLO investors will likely be stuck with those they owned before the coronavirus struck.
“A CLO is like a small bank in the sense that the loan book is the loan book and you’re going to have a bit of trouble turning that ship,” said Tyler Wallace, a CLO manager at London-based Fair Oaks Capital.
In the U.S., more than half of all CLOs now exceed their triple-C limits, according to analysts in Wells Fargo’s investment bank, while in Europe, about a quarter exceed this limit.
For now, the CLO bonds facing downgrades are mostly the riskier, lower-rated ones, but supposedly safer ones could suffer in future if loans keep deteriorating. In stress tests run by S&P on the U.S. CLOs it has rated, nearly 90% of triple-A bonds were downgraded to double-A in its worst-case scenario. That worst case included 40% of loans being downgraded to triple-C and defaults leading to outright losses of nearly 11% across CLO portfolios.
Downgrades for loans and CLOs have barely started. Moody’s alone put $24.5 billion worth of bonds from nearly 400 different U.S. and European CLOs on review for downgrade in mid-April. Altogether, Moody’s, S&P and Fitch Ratings are reviewing more than 1,600 bonds from various CLOs for possible downgrades.
For thousands of private-equity owned companies, that likely means less debt will be available and it will cost more. CLOs aren’t expected to collapse in a wave of firesales, but even industry leaders are skeptical about their ability to keep backing buyouts.
“CLOs won’t be forced to liquidate,“ said Lee Shaiman, a former CLO manager and now executive director at the Loan Syndications and Trading Association. “But CLOs are unlikely to be the main providers of funds for the next round of loans, so the market will have to find new sources of capital.”
Investors Rush Into ‘Pick-Your-Poison’ Junk Bonds
Borrowers are selling debt at low rates and with easier terms, especially in Europe.
Risky companies are selling junk bonds at a record pace, getting ultralow borrowing costs and increasingly loose borrowing terms, such as “pick-your-poison” clauses.
One recent example was the debt package that funded the buyout of Birkenstock GmbH. The maker of frumpy-but-expensive German sandals was taken over in April by the private-equity fund of Bernard Arnault, the French billionaire who controls LVMH Moët Hennessey Louis Vuitton SE.
Birkenstock recently sold €430 million of CCC rated bonds, equivalent to around $522 million, at the riskier end of the ratings scale. The bonds, sold as part of a debt package, yield just 5.25%, comfortably below prevailing market rates. That is despite the debt being worth 7 times the company’s earnings.
The bonds also contain terms that allow the firm to take on extra debt with a pick-your-poison clause, a term coined by research firm Covenant Review to describe a way for borrowers to get around traditional limits on borrowing.
The pick-your-poison nickname comes from the fact that both cash being paid to shareholders and extra debt being added to the business could be “poison” for existing lenders, but the clause lets the owners of the company choose between taking a dividend or borrowing more money.
Birkenstock declined to comment on its debt package.
Borrowers have been able to demand such easy terms because money has flooded into the junk-debt market and particularly into the riskiest parts, where the likelihood of default is highest.
“There is a lot of faith-based investing going on,” said Fraser Lundie, head of credit at Federated Hermes.
Triple-C bonds are the most overbought section of the fixed-income markets, according to analysts at Bank of America. The flood of interest has helped make triple-C bonds the best performing part of the market globally, with returns of nearly 6.5% up to the end of April, they said. That contrasts with the worst performing bonds, 30-year Treasurys, which have lost nearly 14%, they added.
Recent months have brought some volatility to government bond and currency markets, but risky corporate debt has seen prices rise and yields fall consistently over the same period, leaving some investors concerned about returns being too low.
Buoyant markets have helped many companies extend the life of their debt and lower their borrowing costs, making them more stable, Mr. Lundie said. “But particularly in triple-C-rated debt, the share of the market trading in distressed territory is at multiyear lows,” he said.
European borrowers especially have been able to sell debt at low yields and with more aggressive terms.
“Europe is at the sharp end of the stick in terms of highly aggressive, private-equity sponsored deals,” said Alastair Gillespie, a legal analyst at Covenant Review. “Birkenstock is one of the very aggressive top-tier transactions.”
Other deals to have similarly loose terms include Swiss chemicals company Lonza AG and Finnish fiber company Ahlstrom-Munksjö Oyj. In all, nearly 25% of European junk bond deals have had pick-your-poison clauses in the first quarter of 2021, a sharp rise from previous quarters, according to Covenant Review. Among U.S. deals about 14% had such terms, the research firm found in a recent survey.
European corporate debt markets are much smaller than the U.S. because banks still provide a much larger share of financing. U.S. junk bond issuance of almost $200 billion in the first four months of 2021 is well ahead of the previous year-to-date record of $133 billion in 2015, according to Dealogic. It is also much larger than the $73 billion issued in Europe.
But the small size of the debt markets is part of the problem in Europe. More investors are being driven to buy junk bonds because the investment-grade end of the corporate credit market is being dominated by the European Central Bank’s bond-buying programs, said Esty Dwek, head of global market strategy at French fund manager Natixis.
“The ECB is buying so much of the corporate bond market that it is forcing yields down everywhere and forcing investors to take more credit risk,” Ms. Dwek said.
While she isn’t buying more high-yield debt right now, Ms. Dwek said she doesn’t expect a selloff and there will be more discrimination between bonds in the future because issuance has been so large.
Investment-grade yields are so low in Europe that the market is becoming uninvestable, said Tomas Hirst, European credit strategist at Credit Sights. As well as investors putting more money into high-yield debt funds, investment-grade fund managers are already filling up their allowances for risky bonds too, he added.
The strong tide of money into the market is still lifting all risky boats, partly because Europe is behind the U.S. in terms of reopening, which makes it more difficult to pick winners and losers among companies. “In the U.S., things are a bit further ahead and investors are starting to allocate a bit more to potential winners,” Mr. Hirst said.
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