Deteriorating Corporate Debt could be the Financial Crisis Catalyst...
It may seem surprising to assert that the catalyst of the next financial crisis is probably lurking in corporate debt.
A few companies may be rolling in cash, but plenty are not. Companies, in recent decades, have sought to make their balance sheets more "efficient" by raising debt, and taken advantage of the ability to deduct interest payments, for additional tax savings. Businesses, with spare cash, have tended to use it to buy-back shares, either under pressure from activist investors or because doing so will boost the share price, and thus the value of executives' stock options.
A prolonged period of low rates has made it very tempting to take on more debt, with 37% of global companies being highly indebted -- five percentage points higher than they were 11 years ago, just before the previous financial crisis hit. Also, more private-equity deals are loading up on debt, amounts much higher than at any time.
One sign of a upcoming financial crisis is that the credit quality of the bond market has been deteriorating globally, with the median bond ratings having dropped steadily since the 1980s, from A to BBB-. The bond market is divided into investment-grade debt with a high credit rating, and speculative, commonly referred to as "junk" bonds, which are below that level. The dividing line is at the border between BBB- and BB+, with the medium bond rating being now just one notch above "junk."
Even the quality of investment-grade bond debt has gone down, with 48% of such American bonds now being rated at BBB, up from 25% in the late 1990s. Issuers of such bonds are also more heavily indebted than before, with a net leverage ratio for BBB issuers of 2.9, compared to 1.7 in 2000.
Investors are not demanding higher yields to compensate for the deteriorating quality of corporate debt, but just the reverse. In some European countries, investors are demanding no excess return on corporate bonds, to reflect the issuers credit risk. In America, the spread between government and corporate bond yields is at the lowest level in 20 years. Investors have been tempted to buy the bonds, because of the poor returns available on cash, just as low rates have encouraged companies to issue more debt.
In addition, the cost of insuring against a bond issuer failing to repay, as measured by the credit-default-swap market, has fallen by 40% over the last two years -- meaning, investors are less worried about corporate default. However, a model looking at the way banks assess the probability of default, suggest that the risks have barely changed over this period.
Hence, investors are getting less reward for the same amount of risk. Combining this with the declining liquidity of the bond market, because banks have withdrawn from the market-making business, and you have the recipe for the next financial crisis, with already-present ominous signs.
Foreign purchases of American corporate debt has dried up in recent months, and the return on investment-grade debt, so far this year, has been -3.5%.
The withdrawal of Central banks monetary stimulus will eventually lead to liquidity concerns, and further downgrades of corporate bond debt, from investment-grade to the junk rated status, will force companies to liquidate the undesirably rated bond debt, with virtually little demand -- trying to improve their balance sheets and stabilize their companies declining share prices.
Sunday, March 24, 2019
Stock Market Overview -- Financial Crisis Catalyst
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Posted by Private Wealth Management at 6:19 PM