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).

 

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.

 

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”.

 

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:

 

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”:

 

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

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Is the Canary in the Gold Mine Coming to Life Again?
      A Chirp from the Deep Level Mines Back in late 2015 and early 2016, we wrote about a leading indicator for gold stocks, namely the sub-sector of marginal - and hence highly leveraged to the gold price - South African gold stocks. Our example du jour at the time was Harmony Gold (HMY) (see “Marginal Producer Takes Off” and “The Canary in the Gold Mine” for the details).   Mining engineer equipped with bio-sensor Photo credit: Hulton Archive   As we write these...
  • Fed Credit and the US Money Supply – The Liquidity Drain Accelerates
      Federal Reserve Credit Contracts Further We last wrote in July about the beginning contraction in outstanding Fed credit, repatriation inflows, reverse repos, and commercial and industrial lending growth, and how the interplay between these drivers has affected the growth rate of the true broad US money supply TMS-2 (the details can be seen here: “The Liquidity Drain Becomes Serious” and “A Scramble for Capital”).   The Fed has clearly changed course under Jerome Powell...
  • Are Credit Spreads Still a Leading Indicator for the Stock Market?
      A Well-Established Tradition Seemingly out of the blue, equities suffered a few bad hair days recently. As regular readers know, we have long argued that one should expect corrections in the form of mini-crashes to strike with very little advance warning, due to issues related to market structure and the unique post “QE” environment. Credit spreads are traditionally a fairly reliable early warning indicator for stocks and the economy (and incidentally for gold as well). Here is a...
  • The Gold Standard: Protector of Individual Liberty and Economic Prosperity
      A Piece of Paper Alone Cannot Secure Liberty The idea of a constitution and/or written legislation to secure individual rights so beloved by conservatives and among many libertarians has proven to be a myth. The US Constitution and all those that have been written and ratified in its wake throughout the world have done little to protect individual liberties or keep a check on State largesse.   Sound money vs. a piece of paper – which is the better guarantor of liberty?...
  • Fed President Kashkari Hears Voices – Are They Lying?
      Orchestrated Larceny The government continues its approach towards full meltdown. The stock market does too. But when it comes down to it, these are mere distractions from the bigger breakdown that is bearing down upon us.   Prosperity imbalance illustrated. The hoi-polloi may be getting restless. [PT]   Average working stiffs have little time or inclination to contemplate gibberish from the Fed. They are too worn out from running in place all day to make much...
  • US Stocks and Bonds Get Clocked in Tandem
      A Surprise Rout in the Bond Market At the time of writing, the stock market is recovering from a fairly steep (by recent standards) intraday sell-off. We have no idea where it will close, but we would argue that even a recovery into the close won't alter the status of today's action – it is a typical warning shot. Here is what makes the sell-off unique:   30 year bond and 10-year note yields have broken out from a lengthy consolidation pattern. This has actually surprised us, as...
  • Switzerland, Model of Freedom & Wealth Moving East – Interviews with Claudio Grass
      Sarah Westall Interviews Claudio Grass Last month our friend Claudio Grass, roving Mises Institute Ambassador and a Switzerland-based investment advisor specializing in precious metals, was interviewed by Sarah Westall for her Business Game Changers channel.   Sarah Westall and Claudio Grass   There are two interviews, both of which are probably of interest to our readers. The first one focuses on Switzerland with its unique, well-developed system of  direct...
  • Exaggerated Economic Growth of the Third World
      Exciting Visions of a Bright Future Fund Managers, economists and politicians agree on the exciting future they see in the Third World. According to them, the engine of the world’s economic growth has moved from the West to what were once the poverty-stricken societies of the Third World. They feel mushy about the rapid increase in the size of the Middle Class in the Third World, and how poverty is becoming history.   GDP of India vs. UK in 2016 – crossing...
  • Choking On the Salt of Debt
      Life After ZIRP Roughly three years ago, after traversing between Los Angeles and San Francisco via the expansive San Joaquin Valley, we penned the article, Salting the Economy to Death.  At the time, the monetary order was approach peak ZIRP.   Our boy ZIRP has passed away. Mr. 2.2% effective has taken his place in the meantime. [PT]   We found the absurdity of zero bound interest rates to have parallels to the absurdity of hundreds upon hundreds of miles of...
  • Why You Should Expect the Unexpected
      End of the Road The confluence of factors that influence market prices are vast and variable.  One moment patterns and relationships are so pronounced you can set a cornerstone by them.  The next moment they vanish like smoke in the wind. One thing that makes trading stocks so confounding is that the buy and sell points appear so obvious in hindsight.  When examining a stock’s price chart over a multi-year duration the wave movements appear to be almost predictable.   The...
  • How Dangerous is the Month of October?
      A Month with a Bad Reputation A certain degree of nervousness tends to suffuse global financial markets when the month of October approaches. The memories of sharp slumps that happened in this month in the past – often wiping out the profits of an entire year in a single day – are apt to induce fear. However, if one disregards outliers such as 1987 or 2008, October generally delivers an acceptable performance.   The road to October... not much happens at first - until it...
  • Yield Curve Compression - Precious Metals Supply and Demand
      Hammering the Spread The price of gold fell nine bucks last week. However, the price of silver shot up 33 cents. Our central planners of credit (i.e., the Fed) raised short-term interest rates, and threatened to do it again in December. Meanwhile, the stock market continues to act as if investors do not understand the concepts of marginal debtor, zombie corporation, and net present value.   The Federal Reserve – carefully inching forward to Bustville   People...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com