Will the markets continue to soak up corporate credit in incredible volume, and at such low borrowing rates for issuers?
Many CFOs would like them to. But bond investors and credit-rating agencies are saying that, overall, the creditworthiness of nonfinancial corporations is deteriorating. And even issues from cash-rich companies trading at very tight spreads could become less attractive depending on what companies do with liquidity they have built up.
The hunt for yield and exceptional market liquidity aided by Federal Reserve policy is elevating risk for investors in corporate credit, said Standard & Poor’s in a report issued Thursday. According to the S&P, the credit quality of leveraged loan and high-yield bond issuers is already deteriorating.
Among the evidence, the agency says, is that downgrades of junk-bond issuers are outnumbering upgrades for the first time since 2009, and growth in debt is outpacing that of cash flow for U.S. leveraged-loan issuers.
S&P analysts are worried about not only the amount of debt some companies are issuing but also how they are deploying it.
Nonfinancial U.S. companies the S&P rates had a total capital investment shortfall of $175 billion between 2009 and 2011, the credit-rating agency estimates. Highly leveraged companies, in particular, have concentrated on building liquidity rather than investing for the long term, the S&P says, “sowing the seeds for future weakening in competitive positions and creditworthiness.”
“Operating cash flow and cash from financing sources have often not been plowed back into the business, but been kept on the balance sheet as a defensive measure or returned to shareholders,” according to the S&P.
Neither are investment-grade companies immune to deploying debt in a noncreditor-friendly way. Jesse Fogarty, a managing director at Cutwater Asset Management, sees potential “event risk” on the horizon for even high-quality names. With management under pressure to increase equity returns and the cost of debt financing so cheap — nearly “free” when inflation and the tax benefit are taken into account, he says — CEOs and CFOs may pursue shareholder-friendly dividends and buybacks and become more aggressive in managing their capital structure. Leveraged buyouts, like the rumored deal Dell is pursing, are another particularly bad event for bondholders.
“For an investment-grade portfolio, it’s really kind of the ultimate nightmare: waking up to an LBO headline for a credit you own,” Fogarty says.
Fogarty says the peak for credit metrics was in the second quarter of last year. Metrics like coverage ratios may be weakening, but they are doing so off “pretty high levels,” he points out.
The quarterly survey of bank credit-portfolio managers by the International Association of Credit Portfolio Managers (IACPM), released last week, showed those managers also have a negative outlook on 12-month default rates. But fewer of them took that view in the current survey than they did last quarter. “Things haven’t turned out as badly as some people might have feared in Europe or the U.S.,” says Som-lok Leung, the IACPM’s executive director. But “the underlying issues in the world economy are still not completely resolved.”
If bank portfolio managers start to sour on corporate credits, of course, that can cause financial institutions to pull back on originations and be more selective with what debt they hold on their books, says Leung.
Meanwhile, though, U.S. interest-rate policy, with the Fed buying up almost 75% of the supply of mortgage debt, and low volatility in the bond markets continue to drive money into corporate issues, and there’s no solid evidence of any flight out of the asset class. “There’s been so much talk that yields this low can’t persist,” says Fogarty, “but they have.”