The first in a two-part blog on the changing face of corporate debt.
A decade-long generation of quantitative easing led by major central banks has encouraged debt investors to seek and to take on great risks in the pursuit of returns. In simple terms, buyers (lenders / investors) are buying and sellers (borrowers) are selling – and selling like never before.
This is clearly shown through the growth of entry level (BBB) investment-grade bond issuances which have grown from $670 billion at the end of 2008 to $ 2.5 trillion midway through 2018. A large percentage of this debt has been issued to pay for the debt portion of corporate acquisitions that have been completed since 2008. Generally, these have been paid for at acquisition multiples driven up to historical highs by the buyer’s access to cheap and loosely under-written acquisition debt.
Private and public companies have tapped into BBB-rated bonds and correlated bank loans issued by commercial banks to execute their merger and acquisition transactions over the past 10 years. This is also where a large degree of the potential misalignment between risk and return assumptions reside and are open to potentially painful realignment.
Average returns now being earned over individual 10-year issuances of entry point investment grade debt – BBB are currently trading in the 3.5 – 5 % range. When compared to higher quality and higher rated like-term bond issuances of A – AA or U.S. sovereign bonds ( all currently trading at yields from 1 – 3.5 % ), a strong and common sense argument can be made that on a relative, risk-adjusted basis, lenders and investors are not earning anywhere near sufficient returns to adequately compensate them for the underlying risk.
This is particularly true once factors such as liquidity, rising interest rates, business slow-downs and future refinancing risks are correlated into the risk assessment – lenders may actually be taking on equity risk but only earning debt returns
In short, on a go forward basis access to capital and the terms and conditions around that access may change dramatically in the near term. And may spell hard times for overly indebted commercial and corporate bond issuers or borrowers who want to continue to access capital / debt and do so on assured and palatable terms.
A further dislocation in today’s debt markets (and a comparative for commercial or corporate issuers to note) is the current risk and return profiles of bonds issued by meaningful foreign economies. Note that the 10-year bonds issued by Ireland, Spain, Portugal and Italy in the very stressed period after 2008 averaged yields in the 4- 8 % range, while today these same bonds are yielding from negative 0.5 % to 3 %. One could argue the risks and head winds these issuers faced in 2008 have not really abated and may have increased, given current political and social woes.
Assessing Markets and Risks
Current U.S. economic and political policy has spurned an era of hyper competition between global economies and their global or regional governments to pursue or enforce “me first” policies. Their tools are new or increased tariffs, which have only led and will continue to lead to higher prices for commodities, services and products and a more heighted profile of hyper competitive trading. This can only result in increased costs and by default, inflationary pressures. Interest rates will rise, which will only further suppress growth and increase stress over the over-indebted commercial and corporate bond issuers or bank loan obligors referenced above.
The credit markets presently and will continue to remain a canary for equities and the broader risk appetite of investors for debt, equity or other funding to businesses, both public and private. When the music stops, investors will become very defensive and very choosy as to who gets capital and who does not, and if you can raise it, the price you must pay to access it.
Tax cuts in the U.S. have only and can only provide a limited degree and duration of stimulation to the larger North American markets and economy. It is a temporary, one-time hit of sugar to what may become a quickly cooling domestic economy in the U.S. and by default, its largest trading partner, Canada.
The above scenario has an eerie similarity to late 2007, when a similar sense of trepidation over an aging 10-year economic cycle, combined with investors and lenders pouring money into over-heated, misunderstood and over-risked credit / debt markets and related synthetic instruments.
As the treasury yield curve continues to be affected by fiscal policies and a general tightening of monetary policy in North America, the likelihood of an inverted or flat yield curve between the 2-year and the 10-year yields becomes more of a reality. And with it, a harbinger of recession and the end of the current 10-year cycle.
In Part Two, Dan Porter addresses impacts of global politics and technology on markets and gives tips on how to de-risk and insulate your business’ debt obligations.
For more information contact Dan Porter, Managing Director, at 416.515.3877 or email@example.com