Unhedged

Good morning. Bonds can’t make up their minds. In just the past few weeks, 10-year yields brushed 5 per cent, then fell almost 50 basis points. One story on Wall Street is that shorting Treasuries, a high-conviction trade for a while, went too far, and last week was the correction. Confusingly, though, 10-year yields rallied 10bp yesterday, on no discernible news. If you’ve looked deep into the bond market’s eyes and seen its soul, email us: robert.armstrong@ft.com and ethan.wu@ft.com. 

Sooner or later, we are all but guaranteed to get some trouble in corporate debt markets, for the simple reason that rates have risen by almost 5 percentage points in just a few years. Some increase in corporate distress is foreseeable, maybe even healthy. But will it stop at “some”? Is it a matter of the normal credit cycle returning, and companies with fragile financing heading for bankruptcy or restructuring? Or might we be headed for a credit crisis large enough to cause problems at financial institutions, causing market and economic contagion?

These are the questions posed by an excellent Big Read by our colleague Harriet Clarfelt. You should read the whole thing, but we’ll recap the main points.

It begins by disclaiming that things now are fine — that most current defaults are caused by industry- or company-specific issues. But there are worries about the future, as monetary policy continues to squeeze companies and the economy slows. We noted four in the piece: small companies, leveraged loans, extend-and-pretend tactics and private markets. In that order:

Right now, relatively few companies are getting into trouble, but the trend is poor. Moody’s keeps a list of companies that are rated triple-B-negative or lower, that is, companies which are either C-rated (“of poor standing and subject to very high credit risk”) or right on the cusp of it. The Moody’s chart below shows that the size of that list, in both absolute numbers and as a percentage of the whole high-yield (“speculative grade”) universe, are only slightly above the long-term average, while the default rate is still below the levels of 2015-16, when low oil prices caused a series of defaults in the energy sector:

What that chart shows in the future will be determined by how two vectors — the path of interest rates and probability of recession — interact. When debt needs to be rolled over, the cost of new debt and corporate cash flows must co-operate to avoid problems.

To begin with the first vector, rates, the question is how long companies can wait, hoping for inflation to subside and rates to fall. Much, perhaps too much, is made of the “maturity wall”, the point in the future when a large bolus of debt will have to be refinanced. Cramming all high-yield debt together into a single sum, without adding a measurement of companies’ ability to pay, doesn’t tell you all that much. That said, aggregate maturities give some sense of how bad things might get at their worst, and when. And right now, the picture is not too bad in the US, at least for the next two years. The junk bond and leveraged loan markets total $3tn in outstanding debt between them. For less than $150bn of refinancing to cause a credit market contagion, economic conditions will have to be pretty bad. 

Still, a high-rate, recessionary world could be catastrophic for borrowers, who would be pinched by both rising interest expense and falling sales. But such a stagflationary outcome looks remote. More likely is either a low-rates recession, as the Federal Reserve cuts rates to boost activity, or a soft landing where the Fed lowers rates only a little.

A high-rates soft landing is not a common occurrence in history, but chances are it would be survivable. Economic growth gives companies options for staving off default. Capex, a significant expense that is somewhat discretionary, can be cut; so can employment levels. In a pinch, companies can also reduce debt by raising equity, so long as economic conditions are OK. Interest rates are important, but for companies with a functional business model in a growing economy, they are one expense line out of many.

On the other hand, a recession with low rates has happened many times before, and it is plainly bad for creditors, and could be worse this time. Even in a recession, rates might not be as low as the pre- and early-pandemic period in which today’s corporate balance sheets were built. (Virtually every episode of rising default rates in the high-yield bond market is explained by either recession or plunging oil prices, Marty Fridson of Lehmann Livian Fridson Advisors points out.)

So, what are the chances that we get a recession combined with only moderately lower rates, one that starts late enough or lasts long enough to coincide with a high volume of refinancing demand? That is the (slightly long-winded) question. 

It is important to note that bond markets are emphatically not signalling trouble ahead. Spreads over Treasuries of triple-B (lowest rung of investment grade) and double-B and single-B (upper parts of high yield) bonds were higher earlier this year, before long term interest rates jumped, and not far from pre-pandemic levels:

Banks, which have been notably cautious lately, seem to be relaxing a bit, too. The Fed’s latest loan officer survey recently came out, and reported that fewer banks are tightening lending standards for business loans: 

So (consistent with our case for economic optimism yesterday) while there is no doubt that plenty of individual firms will be forced into restructuring by high rates, the chances of a corporate debt crisis seems low as of now. 

But there is an important proviso. One complication in gauging credit risks is that some of the riskiest debt has migrated to private markets. That has been a factor in making public debt markets, especially for high-yield bonds, less risky. Fridson estimates that if default patterns similar to the mild recession in 2001 repeat in 2023, the high-yield bond default rate would peak at 8.5 per cent, versus 11.3 per cent in the dotcom bust, because of better company quality in the public markets. Moody’s forecasts that in a non-recession scenario, the default rate will stay below 5 per cent across public speculative-grade debt.

But even short of a recession, rising defaults may matter most in private markets, which mostly use floating-rate debt. The early signs are troubling. As Harriet’s piece notes, PE-backed distressed exchanges make up a major chunk of this year’s defaults. 

The problem for PE is that it is getting harder to shunt losses on to creditors. Researchers have found that high-yield bondholders in leveraged buyouts underperform bond benchmarks, and the underperformance gets worse the more experienced the PE backer is. Enter private credit, which has snapped up LBO debt by offering faster, nimbler loan execution than public markets in exchange for fatter spreads and tighter contracts. If a company defaults, or needs a distressed exchange, someone somewhere must take a haircut. That is a recipe for a legal knife fight between private lenders and private equity investors, a fight both sides could lose. (Armstrong & Wu)

Some Bored Ape NFT investors burnt their eyes with UV lights. Upside: they won’t have to look at the worthless monkey image they paid $100,000 for?