One of the quieter, yet most emphatic, successes of the Federal Reserve’s long-running easy-money campaign has been the way it has bailed out subprime corporate borrowers. It’s almost as if the Fed has made it “too hard to fail” for mid-sized to large companies with lower credit ratings.
By keeping short-term rates at zero indefinitely and exchanging a fresh $85 billion a month for Treasury and mortgage bonds held by banks and investors, the Fed has stoked investor risk appetites, compressed debt costs dramatically and loosened credit conditions for most decent-sized borrowers.
Junk-bond yields have fallen so far they no longer merit their longtime euphemism of “high-yield debt.” Junk benchmarks now yield around 5.7%, levels that high-grade companies used to be pleased to borrow at. Through most of the 30-year history of the modern junk-debt market, yields were in the double-digits, and in the panic of late-2008 they exceeded 20%.
As a result, the amount of new lower-rated bonds and loans raised by less financially flush companies has been running at record levels. Through October, high-yield bond issuance exceeded $290 billion, according to RBS credit strategists, ahead of last year’s unprecedented pace. “Leveraged loans,” or credit lines extended to lower-rated companies by groups of banks, are likewise being written in amounts previously unseen.
Effects of 'forced generosity'
This “forced generosity” of the credit markets, directed by Fed policy, has a few important effects on the economy and investors.
- Pretty much every company that stands at least a few yards shy of death’s door has been able to refinance its high-cost debt, firming up its financial affairs, buying time and, for many, forestalling balance-sheet distress or even bankruptcy due to still-sluggish revenue and cash-flow production for many.
- As a result, much of the disaster risk has been stripped from the low-grade bond and loan markets. It’s hardly an exaggeration to say that, thanks to this refinancing boom, there are virtually no debt maturities of consequence among “junk” borrowers until 2016, or even 2017. The rush to lock in low rates has been the corporate version of taking advantage of low-rate credit-card balance transfers, hoping their income improves by the time the debt comes due or rates jump higher.
- While this might seem like an unearned gift to riskier companies and their creditors, it’s fair to say the ability of so many borrowers to roll over their debts rather than shrink or fail has saved, at least temporarily, tens or even hundreds of thousands of jobs. This points up the Fed’s broader policy of doing what it can to float the economy long enough for private-sector job momentum to build and consumer finances to recover.
-Trouble is, the policies are keeping many flawed companies alive and independent that should probably fail or be restructured – and the day of reckoning is likely to come in a few years, when interest rates are higher and the financing window has shut for them.
To put some numbers on this “too hard to fail” situation, for the past four years the default rate among both junk issuers and leveraged-loan recipients has been below 2%. Over the next three years, the total amount of debt maturing is meager, with $58 billion due in 2014 and an average of $94 billion a year through 2016 – out of a total of more than $2 trillion outstanding. With no important maturity volume until 2017, J.P. Morgan analysts predict default rates will remain below 2% for the next couple of years.
Confidence with justification
This has lent high-yield investors great confidence, with plenty of justification. Low default rates mean most of the interest can be counted on to be collected without much loss of principal. Sure, absolute yields under 6% are low compared to history. But their spread above comparable Treasury yields – now a gap of more than four percentage points – qualifies as a healthy yield premium versus history.
Investors are feasting on this income; RBS credit analysts point out that last week ended the longest streak of consecutive net weekly inflows to high-yield mutual funds in history.
Tim Gramatovich, longtime high-yield portfolio manager at Peritus Asset Management, points out that, over nearly every market cycle since the modern junk market was born 40 years ago, high-yield has outperformed stocks with less volatility along the way.
Gramatovich, who runs the actively managed AdvisorShares Peritus High Yield ETF (HYLD), believes it’s best to address the market by picking bonds issuer-by-issuer rather than via an index ETF such as the huge and popular iShares iBoxx $ High Yield Corporate Bd (HYG) and SPDR Barclays High Yield Bond (JNK).
The latter funds, while convenient and inexpensive to own, aren’t able to sidestep likely future default prospects such as the big pre-crisis leveraged-buyout issues (huge utility TXU Corp., for one). And they own huge piles of low-yielding debt from relative blue chips such as Ally Financial Inc., simply because they are rated below investment grade and make up much of the index.
He is reassured, broadly speaking, that most newly sold debt from companies enjoying the Fed’s largess are raising cash for relatively sober uses: refinancing, general corporate purposes. While we’ve seen some bonds sold to do huge stock buybacks or pay dividends to financial backers, it hasn’t been the rule.
Still, there is that “maturity cliff” up ahead when creditors will start to knock on the door. David Tawil, co-founder of hedge fund Maglan Capital and a former bankruptcy lawyer, focuses on the bonds and stocks of distressed companies.
He says of the default outlook: “Nothing will really happen until 2016-2017, but when something happens, it will really happen. Companies will continue to skate with rates at zero and then when they come to refinance with a doubling of the interest-rate environment, we’ll start to see things fall out of the sky.
“As the Fed tightens, lenders will be able to be much more choosy, and will leave a lot of companies out in the cold,” he adds. “It should be pretty spectacular.”
In a few years, then, it will likely become — suddenly — quite easy to fail.
- Investment & Company Information