Corporate Debt Levels Cause for Concern

Triggers and Fault Lines

Corona & Aftermath March 10, 2020

Economic growth never dies of old age. Its demise requires a clear trigger: an event or mechanism that causes the onset of a slowdown or contraction. Concerned economists have now identified twin triggers in the disconcerting spread of the corona virus and the sudden collapse of oil prices.

The OECD (Organisation for Economic Cooperation and Development) earlier this month duly adjusted its global growth forecast for 2020 to 2.4 percent, down 0.5 percentage point, whilst the International Institute of Finance, a think tank of banks, is gloomier still and expects the world economy to grow by a feeble 1 percent only.

Recognising that the twin triggers will have a discernible impact on most countries, the economists’ focus has shifted from both immediate threats to the measure of economic resilience present in the major economies. They hope to gauge how well these are able to deal with sudden changes in the dynamics of growth.

At first glance, most Western economies seem well-poised to absorb moderate shocks without too much pain: unemployment is low, corporate earnings are high, and a glut of capital has built up in the property and stock markets. Even after the crash that rocked global exchanges early March, price/earning ratios are still on the high side of reason and caution. Moreover, many countries have managed to re-establish fiscal balance and reduce their debt burdens, building up formidable buffers on the foresight that the good times will inevitably come to an end. If not a virus then something else.

Fault Line

However, the corona scare and the related spat over oil prices between Russia and Saudi Arabia may ultimately open a fault line that so far has remained largely hidden from sight as most eyes are trained on the ticker tape: corporate debt.

According to S&P Global Ratings, non-financial global corporate debt has ballooned to well over $12.6 trillion with financial services providers adding another $7 trillion to the tally. Though the growth of this debt market slowed down significantly in 2019, almost 40 percent of corporate debt corresponds to issuers fielding a rather meagre BBB rating, just two notches into investment grade territory.

In a recent report, the OECD notes that the quality of corporate bonds and other debt instruments has indeed deteriorated markedly since 2008, offering relaxed conditions, longer maturities, and inferior protection for investors. Corporations eagerly plugged into a capital market overflowing with liquidity. Liberal monetary policy, high saving rates, and the slow post-crisis recovery in China and Europe conspired to drive interest rates down to historical lows.

Almost desperately looking for yield, institutional investors upped their risk tolerance profiles to snap up bonds they wouldn’t have touched otherwise. Moreover, and given the hesitant recovery with its attendant weak demand, many corporations have not used their bountiful credit to expand production or boost research and development efforts. Instead, a large chunk of the cash raised through bond issues was used to underwrite share buyback schemes aimed at inflating asset prices.

Europe saw the introduction of ‘QE infinity’ as the ECB (European Central Bank) revived its bond-buying programme last November, earmarking €20 billion monthly for net asset purchases ‘for as long as it takes’ to return both growth and inflation rate outlooks for the Eurozone to ‘satisfactory’ levels. Of that amount €6 billion is destined for corporate debt instruments. By so doing, the ECB seems to admit that Eurozone economies are still unable to keep the momentum under their own power.

As long as the economy keeps humming, albeit at a fairly low pitch, economists find little reason for concern. However, the corona crisis may throw an unexpected spanner in the works, dampening corporate revenues and profits which could well see a number of bond issuers in the tenuous BBB and BBB- range lose their investment grade status. This would force institutional investors to sell their holdings.

Writing in the Financial Times, chief economic adviser of Allianz Mohamed El-Erian warned that a great many relatively young investment funds that focus on the corporate bond market may be forced into a sell-off as spooked clients withdraw their money, leading in turn to higher interest rates.

Triggers

This is already happening in Europe where the yield on corporate bonds rated BBB jumped by 0.8 percentage point in barely four weeks between February and March to 3.2 percent, with issuers in industries most affected by the pandemic paying a premium of an additional 0.5 percentage point. Though still low by historical standards, this sudden increase offers cause for concern. Meanwhile in the United States, investors withdrew $12.2 billion from the corporate bond market in a single week, the highest volume since January 2010.

The money flowing out of the corporate debt market ends up mostly in government bonds. The yield on the benchmark 10-year Treasury note in the first week of March fell to a record low of 1.32 percent, exactly half of the yield recorded this time last year. Meanwhile, 3-month notes paid 1.54 percent. Pundits see in this yield-curve inversion a sign that investors are taking the deteriorating global economic outlook into consideration. Research indicates that a major yield-curve inversion usually precedes an economic downturn by about two years.

Though the US Federal Reserve still has some wiggle room to adjust its monetary policy, and indeed shaved 0.5 percentage point off its federal funds rate, the ECB has largely depleted its monetary arsenal after years of providing extraordinary stimulus. Moving still deeper into negative rate territory than the current -0,549 percent ESTR (European Short-Term Rate) would likely have limited impact.

Instead, ECB president Christine Lagarde has called on European leaders to increase public spending whilst the central bank mulls expanding its TLTRO facility (targeted long-term refinancing operation) that provides banks with money to lend households and small businesses. These funds are disbursed at negative interest rates, so banks essentially get paid twice for extending additional credit: from the ECB and from their debtors. In 2016 and 2017, the ECB injected a total of €786 billion into the Eurozone economy via TLTROs.

For Richard McGuire, lead rates strategist at Rabobank, the ECB is once again engaged in a game of chicken with Eurozone governments. Mr McGuire points out that the central bank is unlikely to win as it cannot afford to remain passive with inflation expectations at or near record lows. Europe’s ‘Frugal Four’ – Denmark, The Netherlands, Finland, and Austria – with a more discrete fifth member (Germany) in tow, are not about to splurge when they can maintain their national accounts in pristine condition whilst the ECB does the dirty work for them – yet another flaw in the Eurozone’s design.

It is then not so much the corona virus, or the arm twisting between Russians and Saudis, that will ultimately decide the fate of the global economy as it is the underlying distortions of global capital markets. If anything, the angst inspired by the virus merely brings these fault lines to the surface.