As balance sheets have become bloated, corporate paper has become more systemically important. Howeverm debt market volatility at the end of 2018 gave everyone a glimpse of the bear lurking down the road.
If there is another certainty besides death and taxes, it is that the credit cycle must come to an end – eventually. A recession is deemed less likely than a gentler slowdown, but some soft spots are keeping market participants up at night; not least because of nightmares about the intricate workouts ahead should a bad economic environment give rise to debt defaults and bankruptcies.
The anxiety centres mainly around the exponential growth in both leveraged loans and BBB rated investment grade bonds over the past few years. The root of the concern is the same in both instances: elevated levels of corporate leverage.
Arguably the most successful debt product has been leveraged loans. Risk-free interest rates remained anaemic for years, driving investors deeper into risk-on asset territory. While the economic environment remains supportive, leveraged loans continue to bring handsome returns, but there is a fear that investors have been lulled into a false sense of security.
Soaring demand has put the power in the hands of borrowers and sponsors, which have progressively slackened covenants – the fail-safes for investors to hold corporates to account on their financials and strategy. In the case of a downturn, corporates can go for longer without having to face creditors, sometimes not until it is too late to turn the ship around.
Listed corporates’ hunt for growth, combined with low interest rates and cheap debt, has led to an abundance of mergers and acquisitions, heavily financed through debt. In many cases, deleveraging programmes have not gone as smoothly as planned; the number of ‘speculative grade’ names, in the layer just above junk status, has ballooned.
As global economic growth figures and earnings forecasts have become gloomier, so has the outlook for much of the corporate debt market. This time around, household balance sheets are in much better shape than those of companies.
