Shifts in Credit-Land: Repatriation Hurts Small Corporate Borrowers

A recent Bloomberg article informs us that US companies with large cash hoards (such as AAPL and ORCL ) were sizable players in corporate debt markets, supplying plenty of funds to borrowers in need of US dollars. Ever since US tax cuts have prompted repatriation flows, a “$300 billion-per-year hole” has been left in the market, as Bloomberg puts it. The chart below depicts the situation as of the end of August (not much has changed since then).

(Click on image to enlarge)

Short-term (1-3 year) yields have risen strongly as a handful of cash-rich tech companies have begun to repatriate funds to the US.

Now, these borrowers find it harder to get hold of funding. This, in turn, is putting additional pressure on their borrowing costs. At the same time, the cash-rich companies no longer need to fund share buybacks and dividends by issuing bonds themselves.

The upshot is that the financially strongest companies no longer issue new short-term debt, while smaller and financially weaker companies are scrambling for funding and are faced with soaring interest rate expenses – which makes them even weaker.

As Bloomberg writes:

“Once the biggest buyers of short-dated corporate debt, Apple along with 20 other cash-rich companies including Microsoft Corp. and Oracle Corp. have turned into sellers. While they once bought $25 billion of debt per quarter, they’re now selling in $50 billion clips, leaving a $300 billion-a-year hole in the market, according to data tracked by Bank of America Corp. strategists.

The reversal is adding pressure to a market already buffeted by Federal Reserve rate hikes. Yields on corporate bonds with maturities between one and three years have jumped 0.83 percentage point this year to 3.19 percent, close to the highest in almost eight years, Bloomberg Barclays index data show. That increase has happened at a faster pace than longer-dated bonds, which tech companies bought less frequently”.

What is really noteworthy about this is that as these corporate middlemen are getting out, the quality of fixed-rate securities available to the rest of the investoriat continues to deteriorate in the aggregate.

Risk Perceptions vs. Risk

Meanwhile, despite the fact that euro-denominated corporate debt is reportedly still selling like hot cakes, both spreads and absolute yields have increased markedly in euro as well since late 2017 (as yields on German government debt are used as sovereign benchmarks for the euro area and remain stubbornly low, credit spreads on corporate and financial debt have increased almost in tandem with nominal yields).

Euro area yields are mainly of interest to us because they were leading to the downside (driven by the ECB’s QE program) and may now be leading in the other direction as well.

Consider the following charts. The first two show spreads and nominal yields on the ICE BofA-ML Euro High Yield Index. While the spread is back to levels last seen in mid-April 2017, effective yields are at levels last seen in late 2016 – about 20 months ago.

Since late June, spreads and yields have essentially moved sideways, which has apparently alleviated any concerns the markets may have had when they spiked initially. Unfortunately for the unconcerned herd, these charts look rather bullish. In other words, it seems as though yields are just consolidating before the next major leg up.

We have a nagging suspicion that this next move will see spreads move up faster than effective yields. As we point out in the chart annotation, for borrowers it is the effective yield they must pay that is relevant, not how it compares to sovereign benchmarks. Spreads only tell us what current risk perceptions are.

Keep in mind that risk perceptions are not the same as risk itself. There is a feedback loop between the two, as low-risk perceptions permit borrowers of dubious creditworthiness to roll over maturing debt with ease. It should be clear though that the virtuous cycle that has compressed both spreads and yields to such low levels can rapidly (and quite easily) turn into a vicious cycle.

(Click on image to enlarge)

European high-yield spreads and effective yields. The cost of corporate debt is still far from alarming levels, but quite a bit of debt was issued at much lower yields, as annual issuance volume has reached one record high after another.

Where the Biggest Danger Lurks

Interestingly, it is actually not the junk bond market that harbors the greatest dangers for investors, at least not directly. Rather, it is the section of the investment grade segment of the market that is rated precisely one notch above junk – the BBB-rated universe.

According to a report by PIMCO from January, the net leverage of BBB-rated non-financial companies has surged from 1.7 to almost 3 between 2000 and 2017 (net leverage = net debt/EBITDA ratio, which indicates how many years it would take a company to repay its debt out of its earnings before interest, tax, depreciation & amortization). In other words, today’s BBB-rated companies are definitely not as bulletproof as BBB-rated companies once used to be. Call it a “sign of the times”.

(Click on image to enlarge)

BBB-rated issuers have seen their effective yields rise to levels last seen more than 31 months ago. At the time junk bond spreads and yields were just coming off a major peak established during the oil patch scare of late 2014 to early 2016. On a relative basis, debtors in this market segment are clearly facing the greatest problem in terms of rising borrowing costs.

But that is far from the only thing that is of concern in this context. The investment grade corporate bond segment is quite large – and BBB-rated bonds actually represent almost 50% of the total these days (!). No other market segment has seen comparable growth in issuance. Here is a chart from PPM America showing the details:

(Click on image to enlarge)

BBB-rated corporate bond issuance has grown to such an extent that these bonds represent nearly 50% of the investment-grade universe these days. At the same time, the leverage of BBB-rated issuers has soared.

We want to draw your attention to the last time the percentage of BBB-rated bonds almost surged to current levels. The difference between then and now reveals a very important point.

From 2001-2003 the percentage of BBB-rated corporate bonds increased sharply due to a recession in which corporate debt was the hardest hit segment of the credit markets. Enormous amounts of capital malinvestment (particularly in the tech sector) had to be liquidated at the time. The ensuing wave of credit rating downgrades was responsible for pushing up the percentage of BBB-rated bonds.

This time, the percentage of BBB-rated bonds in the investment grade universe has soared during a boom rather than a bust. This was inter alia driven by M&A-related issuance, but it would probably be better to simply state that it was (and still is) mainly driven by loose monetary policy and the associated “hunt for yield”.

Here is another chart via Credit Sights that illustrates the situation quite vividly – it compares the face value of outstanding BBB-rated with that of BB-rated non-financial corporate bonds. Note the spike in BBB-rated bond issuance in the era of QE and ZIRP right after the “great financial crisis”:

(Click on image to enlarge)

The amount of BBB-rated compared to higher quality BB-rated bond issuance has soared.

In other words, the aggregate quality of corporate bonds held by investors has deteriorated enormously in recent years. Consider now what is going to happen in the next economic downturn. This time the main impact won’t consist of downgrades of higher rated investment grade (IG) bonds to the lowest IG level of BBB – this time it will consist of downgrades of BBB-rated bonds into junk bond territory.

Since BBB is the lowest IG rating, a downgrade automatically boots the bonds concerned into junk-bond land. Countless tracking indexes and passive investment vehicles exist these days which reflect certain rating buckets. Bonds which are downgraded from investment grade to high yield status are instantaneously removed from IG indexes.

ETFs dedicated to buying and holding investment grade bonds and fund managers whose investments track these bond indexes will become forced sellers – at a time when there will likely be a noticeable paucity of bids for junk bonds. Keep in mind that commercial banks are no longer making markets in corporate bonds either, as they had to abandon proprietary trading due to new regulations that were supposed to make the financial system “safer”.

Conclusion

The liquidity to stop this eventual deluge simply won’t be there when push comes to shove. Current risk perceptions are definitely not reflecting the actual risks extant in credit markets. And no, this time it will not be different.

Charts by Bloomberg, St. Louis Fed, PPM America, Credit Sights