Buttonwood
The big issue
Are credit markets getting frothy again?
Mar 15th 2014
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SETH KLARMAN, who runs Baupost Group, a big hedge fund, is worried. In his latest letter to investors, he writes that “a sceptic would have to be blind not to see bubbles inflating in junk-bond issuance, credit quality and yields.” Recalling the credit boom, he adds that “here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason…and where caution seems radical and risk-taking the prudent course.”
Mr Klarman is right that investors are currently enthusiastic buyers of corporate debt, which offers at least some yield in a world of very low short-term interest rates. In the week to March 5th investment-grade bond funds received inflows of $1.8 billion and junk-bond funds had inflows of $1.1 billion, according to Bank of America Merrill Lynch.
Corporate borrowing costs are lower, relative to government debt, than at any time since 2007. The excess interest rate, or spread, paid by issuers of speculative bonds dropped to 3.6 percentage points in early March, according to Barclays. Historically, issuers of new bonds have had to a pay a premium, in the form of a higher interest rate, relative to bonds that are already trading in the market. In the past six months, this premium has fallen significantly, according to Stephen Dulake, a credit strategist at J.P. Morgan.
In addition, companies have a lot more flexibility when it comes to refinancing their debt. Most bonds have a “call” provision, allowing the issuer to redeem the issue, usually at a price above face value. These calls are most likely to be exercised when interest rates have fallen; companies can then refinance their debt more cheaply.
This is good for issuers but not so great for investors, skewing the risk-reward ratio against them. If things go badly, and the credit quality of the issuer deteriorates, the price will fall; the call will not be exercised and investors will be stuck with an underperforming asset. But if things go well, the company will call the bond early and the investors’ gains will be limited. Hermes, a fund-management group, says the average call period on high-yield bonds in 2010 was 6.8 years; so far this year it has been 3.6.
Some companies have taken advantage by locking in low rates for long periods. Electricité de France, a power company, even managed to issue bonds with a 100-year maturity in January.
It may be surprising that companies are not issuing even more debt. So far in 2014 there has been $595 billion of investment-grade issuance and $82 billion of speculative issuance, according to Dealogic, down from $616 billion and $107 billion respectively at the same stage of 2013. But perhaps companies do not need the money. Low rates have been around for so long that those with debts have already managed to refinance them. And lots of companies have no debt at all. A 2013 study by Deloitte, an accountancy firm, found that non-financial companies had a global cash pile of $2.8 trillion.
That is part of the reason why Mr Klarman’s fears may not be realised immediately. For the market to collapse, one of two things needs to happen: either the fundamentals need to deteriorate sharply or a group of investors have to turn into forced sellers, usually because they have borrowed too much.
In terms of fundamentals, the debt markets could plunge because of a sudden change in monetary policy (linked to a rise in inflation) or because the economy deteriorates so that companies start defaulting in droves. There is little sign of either happening in 2014. Inflation is low in the rich world and, through forward guidance, central banks have indicated that they have no desire to raise rates.
Meanwhile the default rate on all corporate debt was just 1.4% last year, according to Moody’s, a ratings agency; the default rate on speculative, or junk, bonds was only 2.9%. That compares with a long-term average of 4.7% and a peak, after the collapse of Lehman Brothers, of 13.9%. Thanks to a recovering global economy, Moody’s predicts a default rate for junk bonds of 2.2% this year.
As for the people who are buying the debt, they seem more solid than the kind of specialist vehicles that dominated the market in 2006 and 2007. Banks are also less exposed to corporate debt. Goldman Sachs says the finance sector’s commitments to leveraged buy-outs are a fraction of the roughly $400 billion that weighed down balance-sheets back in 2008.
None of this is to say that Mr Klarman will not be proved right in the long run. But we may have to wait a little while to see the top of the market.
SETH KLARMAN, who runs Baupost Group, a big hedge fund, is worried. In his latest letter to investors, he writes that “a sceptic would have to be blind not to see bubbles inflating in junk-bond issuance, credit quality and yields.” Recalling the credit boom, he adds that “here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason…and where caution seems radical and risk-taking the prudent course.”
Mr Klarman is right that investors are currently enthusiastic buyers of corporate debt, which offers at least some yield in a world of very low short-term interest rates. In the week to March 5th investment-grade bond funds received inflows of $1.8 billion and junk-bond funds had inflows of $1.1 billion, according to Bank of America Merrill Lynch.
Corporate borrowing costs are lower, relative to government debt, than at any time since 2007. The excess interest rate, or spread, paid by issuers of speculative bonds dropped to 3.6 percentage points in early March, according to Barclays. Historically, issuers of new bonds have had to a pay a premium, in the form of a higher interest rate, relative to bonds that are already trading in the market. In the past six months, this premium has fallen significantly, according to Stephen Dulake, a credit strategist at J.P. Morgan.
In addition, companies have a lot more flexibility when it comes to refinancing their debt. Most bonds have a “call” provision, allowing the issuer to redeem the issue, usually at a price above face value. These calls are most likely to be exercised when interest rates have fallen; companies can then refinance their debt more cheaply.
This is good for issuers but not so great for investors, skewing the risk-reward ratio against them. If things go badly, and the credit quality of the issuer deteriorates, the price will fall; the call will not be exercised and investors will be stuck with an underperforming asset. But if things go well, the company will call the bond early and the investors’ gains will be limited. Hermes, a fund-management group, says the average call period on high-yield bonds in 2010 was 6.8 years; so far this year it has been 3.6.
Some companies have taken advantage by locking in low rates for long periods. Electricité de France, a power company, even managed to issue bonds with a 100-year maturity in January.
It may be surprising that companies are not issuing even more debt. So far in 2014 there has been $595 billion of investment-grade issuance and $82 billion of speculative issuance, according to Dealogic, down from $616 billion and $107 billion respectively at the same stage of 2013. But perhaps companies do not need the money. Low rates have been around for so long that those with debts have already managed to refinance them. And lots of companies have no debt at all. A 2013 study by Deloitte, an accountancy firm, found that non-financial companies had a global cash pile of $2.8 trillion.
That is part of the reason why Mr Klarman’s fears may not be realised immediately. For the market to collapse, one of two things needs to happen: either the fundamentals need to deteriorate sharply or a group of investors have to turn into forced sellers, usually because they have borrowed too much.
In terms of fundamentals, the debt markets could plunge because of a sudden change in monetary policy (linked to a rise in inflation) or because the economy deteriorates so that companies start defaulting in droves. There is little sign of either happening in 2014. Inflation is low in the rich world and, through forward guidance, central banks have indicated that they have no desire to raise rates.
Meanwhile the default rate on all corporate debt was just 1.4% last year, according to Moody’s, a ratings agency; the default rate on speculative, or junk, bonds was only 2.9%. That compares with a long-term average of 4.7% and a peak, after the collapse of Lehman Brothers, of 13.9%. Thanks to a recovering global economy, Moody’s predicts a default rate for junk bonds of 2.2% this year.
As for the people who are buying the debt, they seem more solid than the kind of specialist vehicles that dominated the market in 2006 and 2007. Banks are also less exposed to corporate debt. Goldman Sachs says the finance sector’s commitments to leveraged buy-outs are a fraction of the roughly $400 billion that weighed down balance-sheets back in 2008.
None of this is to say that Mr Klarman will not be proved right in the long run. But we may have to wait a little while to see the top of the market.
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