Corporate Bonds: The good and the bad
Companies are increasingly turning to bonds for financing but this is not without risk
The Great Recession of 2008 struck a heavy blow to the global economy. Those affected responded by easing interest rates, offering loans, and bailouts. While global growth has skyrocketed since then, there has been a huge build-up in debt for governments and companies all over the world.
Global debt now stands at an all-time high of $169 trillion near the end of 2017. A significant part of that is corporate debt in the form of bonds. The potential in the growing bond market and their risks are the focus of this article.
Understanding Corporate Bonds
Corporate Bonds are a form of debt financing, companies issue bonds at certain interest rates and for a set period of time. When investors buy them, they earn interest till the bond matures at which point they receive the principle. Corporate bonds can be a large source of low-cost capital for a company that has steady earnings and a good credit rating.
A report by McKinsey & Co. shows that many companies have been inclined to move into bond financing over commercial bank lending since 2008. Issuance of corporate bonds has grown 2.5 times over the past decade, leading to the expansion of a larger and more diverse market — which is good news since it helps boost the health of financial markets and eases pressure on banks. However, as more and more companies opt for bonds, the risks from this rapidly growing market is rising.
The bonds are getting riskier
One the largest risks being observed is that the average quality of ‘blue-chip’ (a well-established, financially sound company) borrowers have gone down. Meaning that the average creditworthiness of borrowers has seen a decline over the years. This could result in a larger number of defaults in the years to come as the number of bonds being given is increasing and the cost of doing so will increase as well.
‘Speculative-grade’ bonds have caught the eye of investors, the number of ‘speculative-grade’ or ‘high-yield’ bonds (a high-risk bond with a higher return) has increased. On a global scale, the value of these bonds has almost grown by 4 times, from $500 billion (in 2007) to $1.9 trillion a decade later. Due to the high-risk nature of these bonds, it makes the entire corporate bond market rather vulnerable. In the near future, a huge number of these high yield bonds could require refinancing.
A significant sum will mature soon
Developing countries such as Brazil, Chile, and China amongst others, have seen a spectacular increase in the value of non-financial corporate bonds outstanding. China has close to $2 trillion outstanding. In the next 5 years, a record number of bonds ($7.9 trillion) will mature. The question is whether companies will be able to repay the principal on these bonds when they come through.
Although corporate profits are at record highs, the profits are unevenly spread (meaning that a select few companies are reaping in a large portion of profits, while others are not growing as much).
Rising Interest rates are a threat
Adding another layer to this picture, rising interest rates also have an effect on the risk of corporate debt. In large developing economies, a significant part of the corporate bonds outstanding has been from issuers who are at higher risk of default. In China, these bonds are given by issuers in industrial companies and real estate companies while in India, these issuers are from real estate, healthcare and pharmaceuticals, and materials sectors.
The report showed that a 2% increase in interest rates would drastically increase the risk of default. In India, numbers will rise from 18% to 27% while the numbers in China could rise to as high as 43%, or $850 billion.
There is reason to be cautiously optimistic
The corporate bond market is uncertain. Investor interest could wane if defaults go further up, or if interest on sovereign bonds rises. On the other hand, it is likely that more corporates will choose to go down the path of bond financing in the future, the market has huge potential to grow in Europe, India, and China.
To protect themselves against the risky nature of corporate bonds, investors must adjust their method of approach to this kind of financing, they must carefully research and logically judge corporate borrowers.
Regulators need to enforce greater transparency and reporting, the corporate bond market comes under less scrutiny than equity markets, as it grows, however, this will need to change.
To read the complete report, click here — Rising Corporate Debt Peril or Promise
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