“US junk bond issuance has been prolific, and the quality has been poor,” Gundlach said. “Many issues have been floated with no covenants [legal agreements regarding issuer behaviour].”
But Gundlach also pointed to the huge growth in the so-called investment-grade section of the market — those bonds that boast a credit rating of BBB-minus or above.
“The investment-grade corporate bond market has also grown massive; it is much larger than it was going into the prior credit crisis” he said.
It’s not only the explosion in the size of the investment-grade corporate bond market that’s worrying analysts. They’re also worried about the quality of these bonds.
Boom in Triple B bonds
The decade since the global financial crisis has witnessed an explosion in the issuance of the lowest quality investment-grade bonds — those with a credit rating of Triple B. These bonds have a credit quality that is only slightly above that of junk bonds.
It’s estimated there are about $US3 trillion worth of Triple B bonds, a huge increase on the $US700 billion bonds in 2008.
In fact, Triple B bonds now make up about half the $US6 trillion of the investment-grade bonds on issue. A decade ago, they made up less than a third of the total investment-grade market.
At the same time, high-quality bonds — those boasting a Double A or Triple A credit rating — now represent only about 10 per cent of the investment-grade market, down from almost a quarter two decades ago.
What’s more, these Triple B bonds are now riskier than they used to be because their leverage — that is, debt divided by earnings before interest, taxes, depreciation and amortisation (EBITDA) has climbed sharply since the financial crisis. The debt levels of BBB credits now stand at around 3.2 EBITDA on average, compared with 2.1 per cent in 2007.
Fear of a slowdown
The big fear is that the US corporate bond market could be hit hard if, as many economists predict, the US economy slows and corporate earnings come under pressure.
Debt-laden companies that suffer weaker cash flows will become “fallen angels” as ratings agencies cut their credit ratings to junk status. Other companies will become “fallen angels” because of their failure to deliver on plans for slashing their debt levels.
For the past decade, companies have been easily able to raise debt to fund mergers and acquisitions, and many of the bonds issued sport a Triple B rating. But in many cases the investment-grade rating is conditional on management’s stated resolve to reduce debt levels. An economic downturn or a tightening in financial conditions could play havoc with any plans to cut debt by offloading surplus assets. Delays in cutting borrowings could result in a credit downgrade.
The US corporate bond market will struggle to keep its balance as it tries to find room for these “fallen angels”.
Firstly, many institutional investors, such as insurance companies, are prohibited from investing in junk bonds. When the investment-grade corporate bonds are downgraded to junk territory, they’ll have little choice but to dump these “fallen angels” at whatever price they can get. Indeed, nervous investors will start to dump highly leveraged BBB credits for fear they could be downgraded.
But it’s unlikely the $US1.2 trillion junk bond market will be able to absorb a large and sudden increase in supply. The imbalance between supply and demand is likely to cause a sharp spike in yields. (Yields rise as bond prices fall.)
That bodes ill for companies whose past borrowings are now coming due for repayment. Last year, only about $US50 billion of corporate bonds (both investment-grade and junk bonds) matured. This year, however, some $US700 billion in bonds are coming due for repayment. And that means that many US companies will have no choice but to issue fresh bonds to repay their maturing debt, even if they face higher borrowing costs.
It’s often tempting for investors to ignore potential turbulence in the corporate bond market and to focus on issues dearer to their hearts, such as corporate earnings or valuation ratios.
This is likely to turn out to be an ill-advised attitude to adopt in 2019, because global equity markets will not be insulated from problems in the US corporate bond market.
That’s because equity investors stand right at the back of the queue when it comes to repayment, well behind debt holders. If a company can’t repay its debt holders, then its equity holders will inevitably be wiped out.
Another risk is that the slowdown in the US corporate bond market will finally reveal how cheap debt has powered the rise in the US sharemarket over the past decade.
Since the US sharemarket recaptured its pre-crisis level in early 2011, there have been some $US4 trillion in share buybacks, or about a third of the $US12.5 trillion gain in the S&P 500 over that period.
A shake-out in the US corporate debt market will discourage company chiefs from borrowing to fund fresh share buyback schemes — removing a key pillar of support for the US equity market.