Commentary on Political Economy

Monday, 21 December 2020

THE END OF CAPITALISM ? OR THE START OF A HUGE FINANCIAL CRISIS!

 

Fed backstop masks rising risks in America’s corporate debt market

A surge in borrowing during the pandemic means that the number of ‘zombie’ companies is reaching a new high © FT montage

Investors and analysts surveying the damage wrought by the pandemic have warned that it has exacerbated some of the most worrying trends in corporate debt markets and left balance sheets in a far riskier state.

US companies have borrowed a record $2.5tn in the bond market in 2020. The borrowing binge has driven leverage — a ratio that measures debt compared with earnings — to an all-time peak for higher-rated, investment grade companies, having already surpassed historic records at the end of 2019, according to data from Bank of America.

At the same time, companies’ ability to pay for the increase in debt has declined, with the number of so-called zombie companies — whose interest payments have been higher than profits for three years running — rising close to the historic peak, according to data from Leuthold Group.

Rating agencies have responded to the increase in risk by downgrading credit ratings. A record number of companies were this year rated triple C minus, one of the lowest rungs on the rating ladder — and close to double the number there were last year, according to S&P Global Ratings. 

Line chart of % of US small-cap groups with interest greater than profits for at least three years showing Attack of the zombie corporation

Yet major market players are still preparing for a rally in corporate debt prices next year, with rising risks outweighed by expectations of continued support from the Federal Reserve following the central bank’s historic decision to begin buying corporate debt in March.

“The Fed has created an expectation of a bailout,” said Alex Veroude, chief investment officer at Insight Investment, adding that it, “almost doesn't matter” what other indicators of debt or leverage show. 

“If you think about it is insane,” he said. “It’s exactly what critics would say capitalism has created. But it’s the reality.”

In March, as asset prices tumbled and markets seized up, the Fed announced the unprecedented decision to begin buying investment-grade corporate bonds, as well as exchange traded funds that tracked either the investment-grade or the lower-rated, high yield market. 

Without even purchasing a single bond, prices began to recover, bolstered by the Fed’s support. Investor confidence in corporate America returned and the floodgates opened to fresh corporate debt raising. 

What has followed is the largest corporate borrowing spree on record, allowing companies to plug the hole in their earnings left by the shutdown of the global economy and skirt bankruptcy. The move was widely applauded for averting a more severe crisis. Jonny Fine, US head of debt syndicate at Goldman Sachs, said he viewed it, “as the most important piece of central bank policymaking I have seen in my career.”

Line chart of Yield on ICE Bank of America corporate bond indices (%) showing US corporate borrowing costs tumble

But what began with companies rushing to market to raise cash they desperately needed to stay afloat, transitioned into a red hot debt market, with companies taking advantage of demand to opportunistically sell debt at historically low borrowing costs. 

The surge in borrowing followed a decade of low interest rates that had already encouraged companies to take on cheap debt following the 2008 financial crisis. 

In the summer, the balance of power swung back from investors hoarding cash that companies desperately needed to issuers offering up debt that investors clamoured to buy, leaving them accepting higher risk despite the offer of lower returns.

Private equity companies raised debt to funnel cash into their own bank accounts through so called “dividend recapitalisations”. New ground was broken in the years-long erosion of lender protections in debt documents. 

It means that while the Fed and other central banks have curtailed the severity of the impact from coronavirus, helping open up debt markets to keep companies alive, the concern is that it has simply left businesses comatose on central bank’s life support.

Line chart of Ratio of gross debt to Ebitda showing Bond binge drives rise in corporate leverage

“Companies even in the worst affected industries now look like they will get through the pandemic but what do they look like on the other side?” said Richard Zogheb, global head of debt capital markets Citigroup. “Can they ever get out from this huge debt burden they had to take on?”

Analysts note that companies remain conservative, with much of the cash raised remaining on their balance sheets, rather than shifting to more aggressive activities like stock buybacks. The combined cash balance of S&P 500 companies has risen to a record $3.4tn, up $1.3tn from 2019 and more than three times the level seen in 2008, according to data from S&P Capital IQ. 

Some corporate finance chiefs have also already pledged to reduce leverage going forward. 

Todd Mahoney, head of investment grade debt capital markets at UBS, added that typically a rise in borrowing to recover from an economic downturn is done when yields are high, increasing the borrowing cost to companies. The sharp recovery brought about since March means much of the debt added this year has been borrowed at record low yields. “It’s not as much of a drain on margins,” he said. 

Nonetheless, there remains an open question of whether investors would be as willing to still support companies in their current condition if it were not for the implicit backing of the Fed. 

The central bank’s corporate bond-buying programme is set to end on December 31, but the Rubicon has been crossed and many investors bet the Fed will find a way to step in again if the market is hit like it was in March.

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