Corporate debt – and why it matters

Corporate debt – and why it matters

Lots of companies were heavily indebted before the coronavirus crisis began. Now we face a serious recession, the debt markets are going to see even more action.

31.03.20
by Simon Pilkington
Partner

It’s always worth paying attention to the debt market, even when a thousand other metrics are jostling for your attention. The debt market is, after all, where financing is raised for companies who need it. At the best of times, it is crucial to the functioning of the economy. At the worst of times – and the coronavirus is an economic crisis as well as a human one – its motions are even more important. That’s why the US Federal Reserve took unprecedented steps to buy up corporate debt last week.

So, what does the debt market currently look like? The first thing to note is its sheer scale. In the decade since the global financial crisis, the total value of corporate bonds in the US – which is to say, bonds issued by US corporations in order to raise money – has doubled to around $7 trillion. And this is not some static sum; the market is moving all the time. Corporates issued $57 billion of bonds in just the month of January. Unlike equity, bonds are time-limited and need refinancing, so there is always a need to have a functioning primary market.

The second thing to note is the quality of the debt market. Half of all US corporate debt is now rated BBB, compared to 35 per cent back in 2007. BBB is just two notches above junk status (which is to say, non-investment grade – or high-yield – debt). S&P estimate that there is another $2 trillion of BBB-rated corporate bonds outside of the US, taking the global total to $5 trillion. Mostly these bonds are issued to investment funds, pension funds, insurance companies and non-bank financials; not, generally, banks.

That’s a lot of debt not far above junk status. Perhaps even too much. Some observers are concerned that – just like ahead of the subprime mortgage crisis, when almost everything seemed to be rated AAA – bonds have been carefully structured just to tip the rating over into investment grade territory. Often, the ultimate ownership is obscured by being pooled in funds, which adds to the market’s nervousness. In reality, how many of these companies were already sub-investment grade before the coronavirus crisis?

The effects could be serious. Businesses, after years of low interest rates, are heading into the new recession bearing a heavier burden of debt. And this recession looks set to be worse than others in recent decades; in part because of its intrinsic severity, but also because of its breadth. Previously immune industries will experience significant reductions in turnover that neither their management teams nor the rating agencies would have modelled. The probability of defaults is likely to be higher than the BBB ratings suggest.

But the effects aren’t just limited to defaulting companies and their creditors. Investors holding bonds tend to be sensitive to ratings downgrades to below investment grade – even where there is no default. Insurance companies, for example, have to hold more capital to support investments in non-investment grade debt. Other investors may simply have to sell.

When it comes to the bond funds, which have enjoyed a boom over the past decade as investors “hunt for yield”, we have already witnessed large outflows over the past week or two. Some investors are spooked. Open-ended fund structures may well face liquidity pressure, as investors demand their money back and asset managers are unable to sell the underlying bonds to meet the redemptions.

For the issuing company, operating in this climate, what can it do when the bond matures? How will it refinance? Certainly with greater difficulty. Hence why the US Federal Reserve’s intervention last week was so important. The Fed announced a plan, following similar initiatives by the European Central Bank and the Bank of England, to support the debt market by buying bonds both directly from issuers and also from the secondary market. There is now a new major creditor on the US corporate landscape.

What does all this mean for banks? Even though banks haven’t really bought directly into the BBB-rated bonds, they will still have provided loans to many of the companies that issued those bonds – and, in the event of those companies going bust, the bond debt will often be senior to the bank debt, meaning that it has to be repaid first. So banks could be left counting the costs.

The banks will probably also need to step in to help refinance the holders, as opposed to the issuers, of the bonds. There is certainly a lot of government pressure, around the world, for banks to do more lending – but, as we’ve seen before (for example, Lloyds’ acquisition of HBOS), government pressure is not always in shareholders’ interests.

All that said, the banks are likely to be much better placed than they were in 2008. The improvement in their capital positions over the past decade means that their balance sheets will now be able to withstand a fairly high level of pain.

There is a general awareness among shareholders, in both Europe and the US, that the corporate sector is heavily indebted – and so they are encouraging management teams to focus on cash flow and to preserve cash. This is sensible. The scale and duration of the pandemic’s economic side effects are currently unknown, but most investors are highly sceptical of the idea that this will be a temporary, three-month drop and that there will be a sudden bounce afterwards. The debt market is going to see a lot of action in the months, even years, ahead.

This is a personal view and not intended to be a comprehensive study that picks up the many subtleties in such a varied market.