It’s fair to say that US$12.3 trillion of stimulus seems to have killed off the U.S. credit default cycle. Almost all fear of bankruptcy has been obliterated from debt markets even though the global economy is still struggling under the worst health crisis in a century.
The simplest way to see this is quite basic: The lowest-rated companies are enjoying the cheapest borrowing costs in history. All-in yields on corporate debt rated triple-C and below have fallen to about 8 per cent from as high as 20.2 per cent as recently as March 2020, ICE Bank of America index data show. Investors have raced one another to lend billions of dollars to cruise companies and airlines even as they bleed cash. The amount of U.S. junk-rated debt included in the Bloomberg Barclays U.S. High Yield bond index has surged to a record face value of US$1.53 trillion from US$1.2 trillion in October 2019.
“Ratings agencies have become comfortable with higher and higher leverage, thus companies are more and more happy to take advantage of it,” Noel Hebert, director of credit research at Bloomberg Intelligence, said in a recent article. “There’s an incentive to hold leverage at elevated levels because there’s no real mechanism that’s punishing you.”
It’s easy to look at these valuations paired with more leveraged balance sheets and say risk is being mispriced. Some companies will default, perhaps unexpectedly, even if credit seems priced to perfection now. And yet these yields and low perceived risk of default make perfect sense. In fact, there’s a case for some of these bond yields to go lower.
First, cheap borrowing costs help companies stay alive longer and more easily. That’s a big part of the reason Fitch Ratings just dropped its expected U.S. junk-bond default rate for 2021 to 2 per cent, the lowest since 2017, and doesn’t see it rising much more from that in 2022. About US$90 billion of distressed debt was trading as of April 16, down from almost US$1 trillion in March 2020, according to data compiled by Bloomberg.
Second, government officials have flooded the global economy with cash at an unprecedented pace. Monetary and fiscal stimulus for just the U.S. could have amounted to US$12.3 trillion from February 2020 through March 2021, according to Cornerstone Macro Research data posted on the Wall Street Journal’s Daily Shot.
That’s a lot of money, leaving a lot of cash sitting in savings accounts and looking for assets to buy. Perhaps some investors feel it’s better to invest it with a company that actually makes something or provides real services than, say, a cryptocurrency started as a joke.
The more important question perhaps isn’t whether this is a bubble that will pop soon but rather what are the consequences of this era of free-flowing cash. It prevents the dissolution of businesses that perhaps shouldn't exist, creating so-called zombie companies. And it leaves corporations leveraged to old economies, paying back debt incurred in a past era when they perhaps would rather invest in new technologies amid a quickly changing world.
This debt buildup makes central bankers’ jobs both more difficult and easier in the years to come. It makes it harder because any withdrawal of stimulus, or raising of rates, would be exponentially more painful given the amount of corporate leverage. But it also makes it less likely that conditions will require Federal Reserve officials to raise rates all that much going forward. More debt will pressure longer-term growth and inflation. It reduces economic dynamism.
All this isn’t to say that the lowest-rated bonds can’t lose value in the near term. They can, and according to some investors, are likely to do so. As Oleg Melentyev of Bank of America Global Research wrote in an April 16 note, investors may start to push back after buying a record amount of triple-C rated debt in February.
Funding for these companies “is still wide open, however we think more investors are now struggling at putting their dollars at risk into cap structures levered 14x on a go-forward basis while being paid 650bps to do so, an all-time low,” he wrote. “At some point the reach for yield reaches its limit, and we think it’s here.”
This cycle of low rates and debt dependency can continue for longer than any traditional market watchers would like. The main thing that could stop it is a surge in inflation, which seems likely in the short term but less so over the long haul. This is the new fundamental backdrop. There will be defaults, and all-around returns may be lower going forward, but a true default cycle like those of the past seems a long ways off.
Advertisement