Corporate Bond Defaults Contained For Now — But Caution Needed

Bonds

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  • Despite strong US corporate earnings, corporate debt supply is inching up to historical highs.
  • As rates rise and profits start to cool, these debt burdens will start to pinch.
  • At this point in the cycle, it’s time for investors to start thinking about downside scenarios and rationalizing their portfolio holdings.

Corporate bond analysts are trained to worry. If the best outcome for a bond held to maturity is to get your money back, then a natural reflex is to assume that danger lurks everywhere.

According to a recent survey by Bank of America Merrill Lynch, they are worrying a lot: a record 42% of managers are concerned about overleveraged companies. In February 2018, S&P reported that 37% of global corporations are highly-levered, exceeding the 32% reached during the lead up to the financial crisis.

Corporate Debt Is At All-time Highs 

Despite strong US corporate earnings, debt keeps rising. Headline ratios, such as non-financial US corporate debt-to-GDP, have hit historical highs. Gross leverage, of investment grade (IG) corporate bonds, is also close to record levels.

Corporate debt has almost doubled since the financial crisis as companies borrowed at low yields that made debt service manageable. Prospectively, as the Federal Reserve raises rates and profits start to cool, corporate debt burdens may start to pinch.

At the same time, there has been a notable increase in the percentage of companies that are rated BBB, rising from 10% several decades ago to close to 44% today.

Bloomberg Barclays Indices, Barclays Research

Quality Analysis of Barclays Credit Index, 1973 – 2018

This increase in lower investment-grade debt can be attributed in part to more companies accessing public markets, as opposed to relying solely on banks for credit – leading to a bond market that is more representative of corporate America.

The BBB segment has also grown as corporations have increased leverage and seen their ratings drop.

What Drove Growth In The Bond Market?

In recent years, the largest new debt issuance came from banking, energy, healthcare, technology and telecom sectors, with mergers and acquisitions a key driver.

  • Telecom and media companies like AT&T, Verizon and Comcast borrowed to scale and consolidated their industries.
  • Banks, such as Bank of America, Well Fargo and J.P. Morgan, increased debt to fortify their balance sheets and fund acquisitions.
  • Technology leaders, like Apple, Microsoft and Oracle, started paying dividends and realized that borrowing to fund those payouts rather than repatriate cash helped to avoid a tax bill.
  • In the mid 2000’s, a significant number of companies started issuing debt to fund share buybacks.

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