The risks in riskier debt are rising

The surge in interest rates is not only raising the cost of borrowing for companies, but will inevitably have some impact on their revenues and earnings if the sharp tightening in monetary policies has its desired effect and slows economic growth significantly.

Hopes for a soft landing in the US, or the avoidance of a recession in Europe (where an energy crisis sparked by the war in Ukraine compounds the threat) are receding as inflation continues to rage at historically high levels.

Since the financial crisis in 2008, investors in equities and bonds have chased yield and accepted ever-increasing risks to acquire get those returns. In debt markets, that has seen an overall dilution of the quality of their exposures.

At the riskier end of the spectrum, collateralised loan obligations (CLOS, which are bundles of securitised sub-prime loans) are causing some concern because the proportion of loans rated B – on the brink of junk status – has risen to about 30 per cent, or its highest level since 2008.

It would take the downgrade of only a small proportion of those loans to trigger a requirement for some investors to dump their holdings and flood the market with losses.

The CLOs have the biggest exposure to an even riskier market, the $US1.5 trillion market for leveraged loans. Default rates for leveraged borrowers are rising.

CLOs were seen as attractive because they offer floating interest rates that have risen as the entire rate structure has risen. The flip side of that, of course, is that the interest being paid by the leveraged borrowers has also been increasing.

More broadly, credit quality has decreased in the portfolios of debt investors. According to the Bank for International Settlements, the share of BBB-rated bonds in investment grade bond indices has been steadily increasing as investors have pursued higher yields, with the proportion of AA-rated bonds decreasing – it is about a third of what it was in the pre-financial crisis era.

That, says the BIS, translates into a meaningfully higher risk of losses for investors.

The St Louis branch of the Federal Reserve publishes an index of the effective returns of high-yielding bonds. The effective yield at the start of this year was 4.35 per cent. Now it is 8.6 per cent. For companies with excessive levels of debt, that’s a massive increase in costs.

Looked at another way, the spread between the risk-free benchmark of US 10-year government bonds and junk bonds has blown out from about 3 percentage points at the start of the year to more than 5 percentage points.

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In recent years, there’s been a lot of discussion about so-called “zombie” companies, or companies whose earnings before interest and tax don’t cover their debt-servicing costs.

Research by the BIS and the OECD has suggested that the proportion of zombies in listed company markets has been rising steadily since the 1980s, with a surge in the post-2008 era of cheap and abundant credit.

Their estimates of the proportion of zombies on stock exchanges range from about 12 per cent across the OECD to the low- to mid-teens for markets like Australia and the US. Other estimates are higher.

While generally the balance sheets of companies in the US and other developed economies are in good shape, rising interest rates and the tougher conditions for refinancing debt are bad news for zombie companies.

The credit ratings agencies are predicting a significant increase in bankruptcies over the next year as debt-laden companies struggle to meet the higher borrowing costs within a deteriorating external economic environment.

Warren Buffet once famously said that “it’s only when the tide goes out that you discover who’s been swimming naked”.

Since the financial crisis, the central bankers have kept the tides from flowing out. That has now changed, and we may see over the next year or so who’s been exposed by the sea change in credit conditions. It may not be a pretty sight.

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