Warning signs for the corporate bond market

Markets fear a bloodbath caused by the combination of lower credit ratings, the big short term repayment schedule and the nature of some bond holders. Picture: AFP

Around the world the prices of lower grade corporate bonds are in decline, which is raising the warning flag that there are dangers that have not been taken into account by the share market.

And as a further warning, guess what? A modern equivalent of the securities that helped cause the global financial crisis in 2007-09--- the so-called CDOs (credit default obligations) and CDSs (credit default swaps)----is back in town, reaping big dollars for the promoters.

Every day investors monitor the progress of the Wall Street share market to determine the likely outlook for the US economy.

But the corporate bond market is a far better indicator of what is ahead. The warning signs from this market are now very clear.

The OECD rang the alarm bell last February but the warning was masked by the attention given to COVID-19. The OECD revelations were alarming but since then the situation has been made worse by the impact of the virus.

At the end of 2019 globally there were some $US13.5 trillion ($US13,500 billion) in corporate bonds--- more than twice the amount of bonds that existed in December 2008 in real terms, reflecting the recent chase for yield.

Around 78 per cent of the bonds, or $US10.5 trillion, came from companies based in advanced economies. The remaining $US3 trillion was loaned to companies from emerging markets.

Of the $US10.5 trillion issued by companies in advanced countries a staggering 50 per cent was issued by companies carrying BBB, the lowest investment-grade rating. Any downgrading of these companies would send their bonds into non-rated junk security. Company by company the rating agencies are under great pressure not to take that step because a large number of the holders of these corporate bonds are forbidden by their regulations to hold non-rated securities.

If the economic downturn continues and large numbers of bonds lose their rating the higher risk end of the corporate bond market could collapse.

As well as the BBB bond content of the $US10.5 trillion, another $US2 trillion plus is in bonds that are already non-investment grade, so in all some 70 per cent of the advanced country corporate bond market is in either non-investment grade or close to non-investment grade ranking. Only 30 per cent of the total bond market in advanced countries is rated “A” or above.

The bond market has already discounted the prices for a large number of these danger corporations and theoretical short term interest-rate yields of above 10 per cent are very common.

The market is fearing a bloodbath caused by the combination of lower credit ratings, the big short term repayment schedule and the nature of the holders of these bonds.

At the end of 2019 non-financial companies worldwide had to repay or refinance an unprecedented $US4.4 trillion worth of corporate bond debt within three years. This represented a record 32.4 per cent of the total outstanding amount of corporate bonds--- up from about 25 per cent 10 years ago.

Worse still, $US1.3 trillion was due within one year and $US2.9 trillion within two years.

With bonds selling at a big discount, companies can’t refinance except at a huge interest rate. They must either use their cash, sell assets, make an agreement with bond holders or go into administration.

The holders of these bonds include a great many institutional investors who have legal requirements covering what sort of bonds they can hold. For example, among the largest investors are insurance companies and pension funds which have wide-ranging restrictions on what sort of securities they can invest in. The temptation will be to simply sell the bonds if companies are downgraded. But in a crisis there will be few buyers

Another significant group of holders have members who can access their money at short notice, so potentially placing a lot of bonds on the market at the sell down prices.

Fascinatedly, some 25 of America’s largest companies led by Apple, Alphabet (Google), and Microsoft hold $US356 billion of corporate debt securities. Most of the corporate giants.

if they lose a rating. If the US economy turns down further then all the above danger signals are likely to come into play.

The only bodies that might conceivably avoid a bloodbath are the US Federal Reserve and other central banks. Around 55 per cent of the advanced country bonds are loans to US companies. Potentially it could become one of the biggest single bailouts in history.

But to some extent the central banks caused the problem. Bond issues actually fell in 2018 but when interest rates declined again there was a rush of corporations seeking low interest-rate loans instead of raising equity capital.

The 2019 boom in corporate bonds has attracted the same sort of games as the global financial crisis aiming at sucking in unsuspecting institutions, mainly in the US. Some of these new securities are called collateralised loan obligations or CLOs

Basically the promoters of these CLOs package a big swag of investment-grade bonds (I fear some are BBB) and then slap some highly speculative bonds into the package. Then, hey presto! The rating agencies give the CDOs a high rating so everybody is happy. They are an accident waiting to happen.