As a result of expansionary monetary policy and accommodative regulatory initiatives, the global corporate bond market has seen significant growth over the last decade following the 2008 global financial crisis. At the same time, evidence suggests that corporate credit quality has been declining. Given the elevated risks and uncertainty within the global economy, alongside weaker global growth and lower corporate earnings expectations for 2019 and 2020, the corporate credit market now presents a significant concern which should not be ignored by investors.
Corporate debt is increasing
This week, the OECD (Organisation for Economic Co-Operation and Development) released a report indicating that global outstanding debt in the form of corporate bonds issued by non-financial companies has hit record levels. In its report, the organisation stated that corporate borrowing from bond markets reached almost $13 trillion by the end of 2018, double the amount outstanding in real terms prior to the 2008 financial crisis. This indicates that on average, companies are in twice as much debt, and thus are more exposed to economic weakness, a risk that investors should bear in mind when considering credit exposure.
The report showed that non-financials have dramatically increased their borrowing by issuing corporate bonds. Between 2008 and 2018, global corporate bond issuance averaged $1.7 trillion per year compared to $864 billion per year in the lead up to the financial crisis. Companies from advanced economies (which account for around four-fifths of the corporate bond market) have seen their corporate bond volume grow by 70%, from $5.97 trillion in 2008 to $10.17 trillion in 2018. The corporate bond market in emerging markets was up 395% to $2.78 trillion over the decade. Most of this growth has come from China where corporate bond issuance went from very little in 2008 to $590 billion in 2016, the second largest in the world.
Bond Quality is declining
While the corporate bond market has been rapidly increasing in size, data suggests that the quality of the issuance has been declining. The share of lowest quality investment grade bonds (those rated BBB) is now 54%, a historical high, indicating that the investment grade sector is at risk if economic weakness continues. As weaker corporate earnings and lower global growth begins to impact the ability of corporates to service their debt, these BBB bonds are at risk of downgrade to junk status. As BBB’s now represents a significant chunk of the investment grade market, this would result in significant disruption to credit markets.
According to the OECD data, in the case of a financial shock similar to that of 2008, $500billion of corporate bonds would move from investment grade to junk status, which would likely result in a large sell off in credit markets, as most investors are unable to hold non-investment grade bonds. This would trigger a wider sell off in financial markets.
Compared to the pre-2008 period, there has also been a marked decrease in bondholder rights which could amplify negative effects if the sector runs into difficulty. Covenants are clauses in a bond contract which are designed to protect bondholder rights, however recently there has been a decline in the use of key covenant protection for non-investment grade bonds. This has narrowed the gap in covenant protection between investment grade and non-investment grade bonds, further reducing bond quality. Lower levels of protection may allow companies to escape default for longer, and tend to reduce recovery rates.
According to CreditSights research, the leverage of AA and AAA rated companies in the US has risen to 1.8 times earnings from 1.0 times in 2007. For single A rated companies, leverage has gone from 1.5 times to 2.2 times over the period, indicating that the average A rated issuer today is as leveraged as the BBB rated issuer was a decade ago. The deteriorating quality implies the potential for higher default rates and less capital recovery in the case of a crisis.
Be aware of BBB bonds
BBB rated bonds are the lowest grade of investment-grade bonds, therefore are vulnerable to even a modest shock in markets. Once they are cut to ‘junk’ or non-investment grade status, they become known as ‘fallen angels’ and must be sold off from investment grade funds and by investors only able to hold investment grade debt. In this case, while the issuers of ‘fallen angels’ will face elevated borrowing costs, the influx of non-investment grade bonds may be too much for credit markets, causing volatility and an increase in spreads. In this case, overall borrowing costs increase and default contagion spreads and it becomes harder to refinance debt. With $4trillion of corporate debt to be repaid or refinanced by 2020-21, this could lead to significant problems for the global economy.
Economic weakness is putting swollen debt markets at risk
Economic data now suggests that the global economy is weakening, with lower global growth likely to feed into corporate performance within this half of the year. The following factors are likely to put further pressure on debt markets over the next few months:
- Corporate Earnings
As the global economy weakens, it is likely that corporate earnings will come under strain as a result of weaker consumer demand, with highly leveraged companies becoming less able to service their debt. According to FactSet data, the S&P 500 is expected to report a year on year decline in earnings of 2.7%, and a 0.4% decline in net profit margin in Q1 2019. Further weakness in the economy is likely to result in higher bond default rates, exacerbating financial distress in the markets.
- Monetary Policy
The future direction of monetary policy will continue to influence corporate bond markets, with all eyes on central bank movements in the coming months. Now that central banks have stopped buying bonds as part of quantitative easing and the Fed is selling $50bn of bonds a month, companies will need to compete for capital.
Additionally, given that non-financials will have to pay back or refinance around $4trillion in corporate bonds over the next 3 years, any changes in interest rates will need to be monitored closely. Putting this into context, $4 trillion represents the approximate size of the US Fed’s balance sheet, indicating that risks in the sector must not be ignored.
- Currency movements
Offshore credit denominated in USD has jumped to 14% of global GDP from 9.5% in 2008 as a result of the influx in issuance by Chinese and Emerging Market corporates. This makes the global economy much more susceptible to fluctuations in the dollar. An appreciation in the dollar increases the value of this debt, making it more expensive for corporates to repay.
What does this mean?
In summary, the rapid growth of credit markets over the past decade now presents a significant risk to the global economy, with larger levels of lower quality credit now dominating credit markets. It is clear that tougher regulations on banks since 2008 have made the banks more stable, however the risk has now migrated to investment funds in illiquid assets and corporate bonds, which now make up a much larger percent of the global financial system.
Given the significant risks in the global economy, we encourage investors to choose corporate bond exposure carefully, selecting actively managed options over passively managed alternatives. When the cycle turns, the data suggests that there are significant risks in credit markets which must be considered. At OCM, we choose our corporate bond exposure carefully, and gain access to this asset class through multi-asset funds which manage the exposure actively and on a bond-by-bond basis, evaluating the financial health of the issuer in great detail as part of the selection process. It is our view that the risk in credit markets is significant given the global economic backdrop, and a series of downgrades could become a catalyst for a decline in markets this year.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this half. Overall, global indices rallied over the week on optimism over a US-China trade agreement and the Fed ending its balance sheet reduction, alongside favourable currency movements. The exception to this were UK markets, which declined as a result of sterling appreciation on the back of optimism over an extension of the Brexit deadline. Following a challenging week, the OBI portfolios performed consistently over a volatile week, declining by c.0.2% against a c.0.5% decline in the benchmark.
The economic data continues to support our expectation for a drop back in markets in H1, therefore we remain defensively positioned going forward. It takes time for the data to feed through structurally, therefore as we wait for the data to feed through into markets, we are expecting volatile market conditions to continue, however it is key to bear in mind that the scenario will take time to play out. We must view intra week market fluctuations in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1991, the Gulf war ended after Iraq accepted a ceasefire following its retreat from Kuwait.
Have a great week,
Gina & Jason