The corporate bond market appears dangerously complacent about the zombie threat.
Investors are greatly underestimating the breadth of risk and the power and willingness of the Fed to offer carte-blanche support.
The following article was originally published in “What I Learned This Week” on May 7, 2020. To learn more about 13D’s investment research, please visit our website.
Last year, Surgery Partners — a heavily-indebted network of outpatient clinics majority-owned by Bain Capital — refinanced CCC-rated bonds at a 10% interest rate. By March, with the COVID outbreak beginning, investors braced for Surgery to default, plunging the price of those bonds below 55 cents on the dollar. Then, the Fed announced plans to buy risky corporate debt. Not only have Surgery’s refinanced bonds now rebounded near par, but the company successfully raised another $120 million at a lower interest rate — 9% — than they secured last year.
COVID-19 continues to rage across America. Corporate profits are plunging. Companies are rapidly drawing down on existing lines of credit. Debt downgrades and defaults are rapidly accelerating. Yet, enthusiasm and complacency still define the corporate debt market.
Year-to-date corporate debt issuance sits at a staggering $767 billion (chart below). Between April 13th and April 24th, companies issued a combined $28 billion of speculative-grade bonds, the fourth-largest two-week total on record. Investors have met this spike in supply with fresh demand. The iShares iBoxx USD Investment Grade Corporate Bond ETF has seen its AUM grow by roughly a third since March 11th. Just in the week of April 15th, high-yield funds saw inflows of $7.7 billion, the most of any week since at least 1992.
For years, we have warned about the threat posed by record corporate debt. One in six U.S. companies was already a zombie before the outbreak, meaning their interest expenses exceeded their earnings before interest and taxes. The Fed is now promising unprecedented steps to mitigate pain. Yet, investors are greatly underestimating the breadth of risk and the power and willingness of the Fed to offer carte-blanche support. As Talleyrand said after the Bourbons returned to power in 1815: “They have learned nothing and forgotten nothing.”
It remains unclear what the Fed will buy and how they’ll buy it. From bond ETFs to CLOs, financial engineering has reached an extreme that near-guarantees unforeseeable shocks. Moral hazard is likely to restrain the Fed’s efforts. So might the fear that the American-voting public perceives overreach, triggering a Democrat-led populist backlash. Now is no time to stretch for yield in the corporate-debt market.
Angels are falling and defaults are rising at record speed. The volume of investment grade companies that have been downgraded to junk has already reached $150 billion, surpassing 2009’s record total. And we are still only two months into this crisis. Far more downgrades are to come:
Meanwhile, companies defaulted on over $14 billion in speculative-grade bonds in April, more than three times the total over the same period last year. More brand-name companies are poised for default (chart below). According to J.P. Morgan’s calculations, junk defaults have already reached 4.8%, a 10-year high. Moody’s and Goldman Sachs have both concluded that U.S. junk defaults will surpass 11% by year-end, even with Fed support. Within two years, Bank of America predicts that number will reach at least 21%.
The market is underestimating this threat, as The Wall Street Journal detailed last week:
According to one model developed by Marty Fridson, the chief investment officer at Lehmann Livian Fridson Advisors LLC and a longtime high-yield bond analyst, the market is currently pricing in a 12-month default rate of 8.1%. A different model produced by research firm CreditSights put the market-implied default rate on Friday at 7.4% over the next nine months.
It remains unclear exactly which companies the Fed will be willing to save. In a surprising statement on April 30th, the central bank said it would accept adjusted EBITDA when considering whether to lend to companies. For almost a decade, the Fed has warned banks not to lend to companies with debt-to-EBITDA ratios greater than six times. Companies have sidestepped this guideline by distorting EBITDA calculations. Now, the Fed is poised to reward “the worst abusers,” as former Fed official Mark Carey told Bloomberg last week.
That said, many of the worst abusers are private-equity-backed companies and it appears they will be largely excluded from the Fed’s bailout program. This could be a problem for the Fed’s junk bond ETF buying plans. As Robert McCauley, a senior fellow at Boston University, calculated for the FT last week, it is possible as much as 20% to 30% of the iShares iBoxx $ High Yield Corporate Bond ETF could consist of bonds issued by firms owned by private equity. “If the Fed buys HYG, what fraction of its investment goes into bonds of highly-leveraged firms owned by PE firms?” McCauley wrote. “It is easier to pose this question than to answer it.” Until the Fed actually begins lending to heavily-leveraged firms or buying junk-bond ETFs, we remain skeptical about how far the central bank will be willing to wade into moral hazard.
The fact that the CLO market is in crisis will only make it more difficult for zombie companies to raise the cash necessary to avoid default. Between 2015 and 2019, CLOs funded 58.4% of primary leveraged-loan origination in the U.S. Now, CLO demand has all but dried up.
CLOs can only hold so much CCC debt — typically 7.5%. Downgrades have come so quickly — S&P and Moody’s have cut ratings on roughly 20% of loans held by CLOs — the vast majority of CLOs have “blown past the CCC cap,” according to Bank of America. This has a three-fold effect: 1) CLOs must dump assets at fire-sale prices. 2) They have to suspend cash payments to investors (roughly 20% of CLOs have already turned off some cash flow to equity investors). And 3) they have to retreat from extending capital to highly-leveraged buyers.
Deutsche Bank recently cut its forecast for new U.S. CLO sales by 40% to $55 billion. We doubt the Fed will step in and help much in this area. The central bank has yet to define collateral requirements for loans to large and medium-sized businesses. In the past, it has generally required loans to be fully secured by collateral, meaning they “will not help those highly leveraged companies that do not have unpledged collateral,” as Harvard Business Review commented last month.
The market does appear to recognize the Fed isn’t offering a panacea for the zombie threat. As Dave Rosenberg pointed out this week: “The Fed has blown its brain out on ZIRP and QE and all we get is a retracement…[of] 50% in the junk bond market, and, in the end, the average interest rate in the junk bond market, at 8.13%, is 312 basis points higher than it was before the crisis started in mid-February.” The weakest firms are the reason for this interest-rate climb. The top-rated tier of junk bonds, BBs, offer a yield of just over 5.5%. Meanwhile, the interest rate of the lowest-rated tier, CCCs, now exceeds 16%.
That said, record inflows into junk bond ETFs and continued lending to zombie firms suggests complacency remains too high. Even before the outbreak, zombies needed constant debt infusions to survive. Now, profits are tumbling. A V-shaped or even U-shaped recovery is doubtful. Will the Fed actually save zombies when they know it’ll mean a devastating blow to their credibility? How big will the political backlash be if they continue piling debt on top of bad debt and inequality only gets worse?
The following article was originally published in “What I Learned This Week” on March 7, 2020. To learn more about 13D’s investment research, please visit our website.
