As bond investors seek a better return than the poor yields on advanced country bonds, they eye up the higher income available on some company debt.
There has been a sharp increase in so called levered loans. These are bonds issued by larger companies, often at a floating rate of interest related to official interest rates. They are lent to companies that already have substantial regular borrowings, and are often used for capital spending or buy in of shares. The banks that set them up often sell these loans on in a securitised form so individuals and other companies in the market can share in these debt obligations and take the risk of the company failing to pay the interest or defaulting on repayment. Various central banks have highlighted this build-up of levered debt, particularly in the US, and suggested it is a worrying risk in the system.
So far, the bankruptcy rate for companies has remained very low. Low interest rates help, making the debt more affordable. The continuing growth of the US economy helps, making it more likely companies can increase their revenues. The big corporate tax cuts helped, leaving more cash in company bank accounts to pay the business bills. Usually a build-up in debt by companies only becomes a major problem when rates rise. This can make it difficult to afford the interest charge, at a time when the economy slows, hitting company revenues. As an economy flips over into recession so there will either be more bankruptcies, or banks will put companies into a kind of informal administration demanding their managements conserve cash and rein in expansion and costs to keep the loans they have taken out.
Those who think the $1.3 trillion increase in levered loans in the US is too much, fear either rate rises which make more of this debt unaffordable or they fear that when a company has to roll over or renew its levered loan the banks will decide it was too much after all. There are companies, and even whole sectors, that will get into trouble even without a general rate rise or overall recession. Retailers struggling with costly property chains on high streets and in malls may get into financial trouble anyway. Commodity based companies such as oil companies can get into difficulties if their commodity prices fall too much even without a general recession. To date these localised problems have been contained. Since the 2008-9 crisis banks seem to have got used to extending more credit and working behind the scenes to secure their loan by demanding asset sales or new management or takeover.
The market typically expects extra income for the additional risk of these corporate loans. It expects even more of a premium income where a company bond has junk status with greater fears of bankruptcy. Investors have to decide just how much extra risk they are prepared to take, and assess the likelihood of big loss. The High Yield market has more of the characteristics of the share market, with such bonds doing well when an economy expands and investors are optimistic about growth and general prospects. High yield did well in the first two months of this year as confidence returned to share markets and as recession fears receded. All this leaves yields on corporate bonds offering less of an income gain over lower risk bonds, meaning this is not such a good time to buy. Whilst we are not forecasting a big meltdown from a sudden acceleration in bankruptcies, we do expect a continuing run of bad news from distressed sectors and from companies on the wrong side of the digital revolution.
Emerging market states issue bonds which on the whole offer much better income levels than advanced countries to reflect the added risks of poor economic policy. In some cases poor economic performance leads to currency losses and even in extreme cases like Venezuela and Argentina to default. These bonds overall had a poor year in 2018 with substantial currency losses for some against the strong dollar. This year better economic policies in Brazil and the sign of a bit more stability in mainstream emerging market currencies make these a more interesting investment. These bonds are much more volatile than short dated advanced country government bonds, but are a way of increasing the running income and maybe even adding some capital gain in a bond world where returns on safer instruments are very low.
The above article was previously published by Charles Stanley on 22nd March 2019