The Seeds of the Next Financial Crisis

The Fed's half a percentage point rate cut may very well have been its best efforts at helping the struggling corporates. With sales dropping at least this rate cut will help with their cash flow when servicing their growing debts...  

From the Financial Times: 

The Seeds of the Next Financial Crisis

In the short term the behaviour of credit markets will be critical. Despite the decline in bond yields and borrowing costs since the markets took fright, financial conditions have tightened for weaker corporate borrowers. Their access to bond markets has become more difficult. After Tuesday's 50 basis-point cut, the US Federal Reserve's policy rate of 1.0-1.5 per cent is still higher than the 0.8 per cent yield on the policy-sensitive two-year Treasury note. This inversion of the yield curve could intensify the squeeze, says Charles Dumas, chief economist of TS Lombard, if US banks now tighten credit while lending has become less profitable.

This is particularly important because much of the debt build-up since the global financial crisis of 2007-08 has been in the non-bank corporate sector where the current disruption to supply chains and reduced global growth imply lower earnings and greater difficulty in servicing debt. In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates.

...

A comparison of today's circumstances with the period before the financial crisis is instructive. As well as a big post-crisis increase in government debt, an important difference now is that the debt focus in the private sector is not on property and mortgage lending, but on loans to the corporate sector. A recent OECD report says that at the end of December 2019 the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn, double the level in real terms against December 2008. 

The rise is most striking in the US, where the Fed estimates that corporate debt has risen from $3.3tn before the financial crisis to $6.5tn last year. Given that Google parent Alphabet, Apple, Facebook and Microsoft alone held net cash at the end of last year of $328bn, this suggests that much of the debt is concentrated in old economy sectors where many companies are less cash generative than Big Tech. Debt servicing is thus more burdensome.

...

In a downturn, some of the disproportionately large recent issuance of BBB bonds — the lowest investment grade category — could end up being downgraded. That would lead to big increases in borrowing costs because many investors are constrained by regulation or self-imposed restrictions from investing in non-investment grade bonds. 

The deterioration in bond quality is particularly striking in the $1.3tn global market for leveraged loans, which are loans arranged by syndicates of banks to companies that are heavily indebted or have weak credit ratings. Such loans are called leveraged because the ratio of the borrower's debt to assets or earnings is well above industry norms. New issuance in this sector hit a record $788bn in 2017, higher than the peak of $762bn before the crisis. The US accounted for $564bn of that total. 

Read the whole article on the FT here: https://www.ft.com/content/27cf0690-5c9d-11ea-b0ab-339c2307bcd4

bit.ly/PangeaBlog

bit.ly/PangeaFeeds