Vultures start to circle corporate bonds

Bloomberg USD High-Yield Corporate Bond Index chart

“Every party has to end,” says The Wall Street Journal. Since the financial crisis, record-low interest rates and printed money have inflated a bubble in corporate borrowing. But now it’s leaking air. In the first nine months of 2015, non-financial firms across the globe issued a record $1.38trn in investment-grade debt. The American figure was also a record: $570.4bn. In total, US firms have $7.8trn in debt. Around $2.5bn is “junk” – riskier debt from those with lower credit ratings. Such bonds now trade on single-digit yields (yields fall as prices rise) due to their popularity – last year, investors scooped up $312bn of junk, compared to $146bn at the last peak in 2006.

The cycle turns

But now “we are in the late stages of the credit cycle”, says Edwin Tai of Newfleet Asset Management. The market has been going off the boil. Investors, sensing a slowdown, are starting to demand higher interest rates amid fears they may not be repaid. US junk yields have risen to around 8% as prices have slid (see chart above).

The yield on corporate debt is always higher than on government bonds, reflecting the extra default risk – the “credit spread”. Now spreads are widening, and the gap between the best corporate paper and riskier debt is also rising. Spreads for the lowest-level US investment-grade bonds, rated BBB, are at their highest for this cycle.

The spread between triple-B and double-B, the top end of the junk market, is at a six-year high. And this isn’t limited to troubled sectors such as oil and mining. Already, more American companies have defaulted than at any time since 2009, with Quiksilver, the surfwear retailer, a notable casualty, say Eric Platt and Nicole Bullock in the Financial Times.

So far the default rate on high-yield debt is well below the historical average, and there has not yet been an investment-grade default. But the proportion of US bonds deemed “distressed” – those with a yield that’s at least 10% higher than government debt – is at a four-year high. What’s more, $1.5trn of corporate debt has to be refinanced in 2016 and 2017. And American firms may have trouble servicing their debt once earnings fall or interest rates rise: JPMorgan reckons that 62% of firms have twice as much debt as cash flow from operations, up from 31% in 2006.

Stresses emerge

Emerging markets have also “become caught up in a new credit bubble”, says Gillian Tett in the FT. According to the International Monetary Fund, emerging-market company debt more than quadrupled to $18trn between 2004 and 2014, and is now worth 74% of those countries’ GDP. Debts are worth twice equity, making balance sheets look very stretched.

The good news is that foreign-currency debt accounts for just 5% of the total, says investment manager T. Rowe Price, so the squeeze as falling local currencies make foreign debts more costly should be limited. But the emerging-market slowdown, notably in commodities, will push junk defaults up to 5.4% this year from 3.2% in 2014, estimates JPMorgan. And if US rates rise, money may continue to leave emerging markets.

The size of the corporate debt bubble hints at turbulence when it bursts. It doesn’t help that bond-market liquidity is lower than usual as a side-effect of new banking regulations. Rising credit spreads aren’t a foolproof sign of a recession, says The Economist’s Buttonwood columnist. But financial stresses are emerging. “One swallow does not make a summer. But the sudden appearance of a vulture circling overhead ought to raise serious concerns.”