The walking dead and the end of the thirst for yield
As rates stayed low - just not as low as they are today - more and more companies with “just OK or bad” balance sheets borrowed and borrowed from 2009 through 2020 (to date) thanks to the massive appetite for yield, which resulted in lots of corporate bank loans and high yield bonds on the balance sheets of banks and inside portfolios of fund managers trying to make money, beat benchmarks (or just collect fees and pretend they’re experts).
The bond market’s size is huge - it is way larger than the global equities. As of 31 December 2018, for example, the entire US bond market (bond debt outstanding) was at $102.8 trillion, according to SIFMA. In comparison the US equity market capitalisation was $74.7 trillion (SIFMA Fact Book 2019).
Loan issuance generates fees. Bond issuance generate fees. Both types of financing grow assets for banks and justify what your (pension) fund manager can do with all the trillions of assets under management.
High yield funds look like this Black Rock’s HY fund https://www.blackrock.com/us/individual/products/227557/blackrock-high-yield-bondinstitutional-class-fund#holdings or this iShares HY ETF https://www.blackrock.com/us/individual/products/239565/ishares-iboxx-high-yield-corporate-bond-etf#holdings …
These large loans and bonds (some backed by sub prime car loans, student loans and high interest credit card debt) and smaller loans to smaller companies have created an army of the walking dead too - small, medium and even large companies that don’t have enough income in the form of EBIT (operating profit) to service their “mortgages”.
The zombies’ share of the market appears to be growing. About 17% of the world’s 45,000 public companies covered by FactSet haven’t generated enough earnings before interest and taxes (EBIT) to cover interest costs for at least the past three years. Bank for International Settlements economists, using a similar but narrower definition, find that the world’s equity markets’ share of zombies has risen to more than 12%, up more than 8 percentage points since the mid 1990s.
If you couldn’t afford it, you could still borrow it - but only if you could convince a bunch of investors - including Black Rock and others - that you could borrow later again to repay what you couldn’t afford in the first place. The fees were great but the party has ended.
Until next time.
Corporate borrowing costs soar amid default fears
Interest rates for even highly rated companies double from levels of days ago
Borrowing costs for companies around the world are rising dramatically despite central bank interest rate cuts as rating agencies warn that the economic impact of the coronavirus will lead to a surge of corporate downgrades and defaults.
Fears about creditworthiness are prompting investors to put their money in the most easily traded securities — such as short-term government debt — raising borrowing costs for more highly rated corporate borrowers and choking off credit to riskier ones.
Rating agency Moody’s estimates the default rate for speculative-grade companies could hit nearly 10 per cent, with energy companies particularly hard hit. That is up from 2.3 per cent a year ago, and a historical average of 4 per cent.
“I think the pandemic coupled with the oil price crash and the asset price declines are creating a severe and extensive credit shock across regions, sectors and markets,” said Anne Van Praagh, a researcher at Moody’s.“The combined credit effects are unprecedented. This is not like anything we have seen before.”
(Moody’s on its site says: “Anne re-joined Moody’s in June 2009 following three years at Morgan Stanley. There she worked as an investment banker on 30 senior managed financings in transportation and infrastructure. During the preceding eight years, Anne worked on a variety of Moody’s rating teams within the US Public Finance Group, including in the US states and infrastructure ratings team.”)
Even highly rated companies that have been able to sell bonds during the outbreak have agreed to deals that will increase their total financing costs by hundreds of millions of dollars as revenues are threatened by an economic downturn.
The average yield for investment-grade corporate debt has risen from a year to date low of 2.26 per cent two weeks ago to almost 4.5 per cent on Thursday, according to an index run by Ice Data Services.
“It’s brutal. We have never seen such a big move in such a short amount of time,” said Monica Erickson, a portfolio manager at DoubleLine. “This is the quickest and most severe I have ever experienced, and I was around for 2008.”
For higher-risk “junk” rated companies, the sell-off has been even more severe, with the average yield on an index run by Ice doubling this month to over 10 per cent.
“Companies are focused on increasing liquidity, drawing down revolvers and accessing cash wherever possible. They are preparing for the worst because we are in an unprecedented environment,” said Ms Erickson.
If it’s in the news, it’s already late for some.