GFC Mk II could be triggered by subprime corporate loan crisis

This weekend I write about how GFC Mk II could be triggered by a subprime corporate loan crisis. A new record was set this week for the lowest-ever recorded yields on US corporate bonds, which means it has never been cheaper for firms to borrow money. This reflects both super-tight credit spreads coupled with ultra-low risk-free rates. The flip-side is that lenders (and investors) have never received worse compensation for the risk of companies (not banks) defaulting on their debts at a time when US corporate (not bank) leverage has climbed to levels that are higher than those observed before the crisis. To read the full column, click here (AFR subs can click here). Excerpt enclosed:

As this column has repeatedly warned, credit spreads on high yield, or sub-investment grade (aka "junk"), corporate bonds, and more robustly rated “investment-grade” corporate debt, in the US have slumped to below the absurdly low levels last evidenced back in the heady days of 2007.

Concurrently there has been a surge in riskier corporate lending. Writing in a 2019 edition of the Journal of Fixed-Income, legendary debt investor Daniel Zwirn and two academic co-authors conclude that “today’s BBB corporate bond is yesterday’s [junk] BB”.

“There has been an alarming increase in the number of BBB bonds issued after 2014,” they write. “The BBB market is not only more crowded, but, disconcertingly, it is also riskier (on a comparable basis) by virtue of having more leverage, as measured by debt divided by EBITDA.”

Compared with average BBB leverage of two times during the 2008 crisis, Zwirn et al show this metric had crept up to 3.2 times by 2018. They further cite Morgan Stanley research that finds that if companies were rated on leverage alone, “over a quarter of the investment-grade [bond] market would have a high-yield [or junk] rating”.

This has coincided with a boom in riskier private debt and “leverage loan” lending to mid-market businesses that cannot access the cheaper investment-grade or bank-intermediated sectors. Drawing parallels with the 2008 cataclysm, Zwirn et al argue that “a leverage loan and a subprime mortgage share common features”.

“A subprime mortgage is created for individuals with poor credit in the same way that a leveraged loan is created for corporations with poor credit ratings. According to the definition of S&P Leveraged Commentary & Data, a leveraged loan is typically for borrowers with low [junk] credit ratings of BB [or less] or any loan that has a borrowing rate of at least LIBOR [ie, the cash rate] plus 125 basis points and no current rating.”

In the US there has been a sharp increase in this type of subprime corporate lending and “covenant-lite” loans akin to the mortgages written with relaxed lending standards prior to 2008. “It is reasonable to think of pre-crisis subprime mortgages as leveraged loans because the customers for both are weak borrowers with poor to no credit ratings,” Zwirn et al maintain.

“The greatest danger leverage poses is its ability to amplify otherwise small levels of uneasiness in the system, which can trigger a systematic shock. This happened in the subprime market in the past and it can happen in the corporate credit market now. With economic downturns occurring on a dependable cycle, it is only a matter of time before we witness and suffer the consequences of an overleveraged credit market implosion.”

This should give pause to those retail and institutional investors falling over themselves to buy high-yield debt originated in the US and Europe. On our estimates, the credit spreads paid on both BBB and BB rated corporate bonds in the US are about 20 to 30 basis points below their previous historic tights recorded in 2007.

This contrasts with the credit spreads on bank-issued senior bonds, which are as much as 8 to 9 times wider than what investors earned in 2007 despite the fact the banks have radically deleveraged their balance-sheets. In 2007 CBA reported a common equity tier one capital ratio of just 4.7 per cent. Today that ratio has jumped to over 12 per cent. Put differently, CBA's risk-weighted leverage has shrunk from 21 times in 2007 to 8 times today.

CBA has also dramatically de-risked its broader business model. This deleveraging combined with a huge increase in commercial risk-aversion reinforced by massive re-regulation has effected a long overdue transfer of wealth up the capital structure from bank shareholders to their historically maligned depositors and creditors.

One problem Australia does not yet suffer from is a burgeoning high-risk corporate debt market given the historic dominance of the big banks. Indeed, a key policy priority is to support the growth of more corporate lending and bond issuance outside of the core banking system, which the likes of Metrics have helped pioneer.

Read the full column here.