by Judith Stein and Biodun Iginla, The Economist Intelligence Unit News Analysts
A sea of debt
Corporate bonds and loans are at the centre of a new financial scare
The pool of corporate lending has risen to $74trn
OVER THE
past decade officials—and some bankers—have tried to redesign the
financial system so that it acts as a buffer that absorbs economic
shocks rather than as an amplifier that makes things worse. It faces a
stern test from the covid-19 virus and the economic ruptures it has
triggered, not least a Saudi-led oil-price war (see next article). The
locus of concern is in the world’s ocean of corporate debt, worth
$74trn. On Wall Street the credit spreads of risky bonds have blown out,
while in Italy, a bank-dominated economy that is already in lockdown,
the share prices of the two biggest lenders, Intesa Sanpaolo and
UniCredit, have dropped in the past month by 28% and 40% respectively.
The
scare has four elements: a queasy long-term rise in borrowing; a
looming cash crunch at firms as offices and factories are shut and
quarantines imposed; the gumming-up of some credit markets; and doubts
about the resilience of banks and debt funds that would bear any losses.
Take
the borrowing first. Companies came out of the 2007-09 financial crisis
in a relatively sober mood, but since then have let rip. Global
corporate debt (excluding financial firms) has risen from 84% of GDP
in 2009 to 92% in 2019, reckons the Institute of International Finance.
The ratio has risen in 33 of the 52 countries it tracks. In America
non-financial corporate debt has climbed to 47% of GDP from 43% a decade ago, according to the Federal Reserve.
Underwriting standards have slipped. Two-thirds of non-financial corporate bonds in America are rated “junk” or “BBB”, the category just above junk. Outside America the figure is 39%. Firms that you might think have rock-solid balance-sheets—AT&T—have
seen their ratings slip, while others have been saddled with debts from
buyouts. Naughty habits have crept in: for example, using flattering
measures of profit to calculate firms’ leverage.
All
this leaves business more vulnerable to the second factor, the shock
from covid-19 and the oil-price slump. Some 7% of non-financial
corporate bonds globally are owed by industries being walloped by the
virus, such as airlines and hotels. With oil close to $35, America’s
debt-addicted frackers and other oil firms are in trouble. Energy is 8%
of the bond market.
A far broader set
of firms could face a cash crunch if temporary shutdowns and quarantines
spread. In China over the past months, financial distress—and informal
forbearance—has been widespread. One multinational says it has relaxed
its payment terms with suppliers in China. HNA, an outrageously indebted conglomerate than runs an airline, has been bailed out.
To get a sense of the potential damage in other countries The Economist
has done a crude “cash-crunch stress-test” of 3,000-odd listed
non-financial firms outside China. It assumes their sales slump by
two-thirds and that they continue to pay running costs, such as interest
and wages. Within three months 13% of firms, accounting for 16% of
total debt, exhaust their cash at hand. They would be forced to borrow,
retrench or default on some of their combined $2trn of debt. If the
freeze extended to six months, almost a quarter of all firms would run
out of cash at hand.
The near-certainty
of rating downgrades and defaults in the travel-related and oil
industries, and the possibility of a broader crunch, is the third
concern. Credit derivatives, the most actively traded part of the
fixed-income markets, have recoiled. The CDX index, which
reflects the cost of insuring against default on investment-grade debt,
is at its highest level since 2016, as is the iTraxx crossover, which
covers riskier European borrowers. Out of the public eye, privately
traded debt may now only change hands at heavily discounted prices. The
issuance of new debt has “dried up”, says the head of a big fund
manager. This could fast become a serious problem because firms need to
refinance $1.9trn of debt worldwide in 2020, including $350bn in
America.
Fractured markets mean the
fourth element, the resilience of the institutions that make loans and
buy bonds, is critical. A majority of American bonds are owned by
pension funds, insurers and mutual funds that can cope with losses. But
some will be reluctant to buy more. And 10-20% of all American corporate
debt (bonds and loans) is owned by more esoteric vehicles such as
collateralised-loan obligations and exchange-traded funds. Such
exposures have yet to be fully tested in an extended period of severe
market stress.
Who, then, can act as a
source of stability and fresh lending? Some big cash-rich firms such as
Apple could grant more favourable payment terms to their supply chains.
Private-equity firms have capital to burn. But in the end much will rest
on the banks, who have the relationships and flexibility to extend
credit to tide firms over. America’s banks have their flaws—Goldman
Sachs is sitting on $180bn of loans and lending commitments with ratings
of BBB or below, for example. But broadly speaking they are in reasonable shape, with solid profits and capital positions.
Outside
America the picture is less reassuring. Europe’s banks make puny
profits, partly because interest rates are so low; Italian banks had a
return on equity of just 5% last year. Since the virus struck, the cost
of insuring their debt against default has flared up, hinting that they
could yet become a source of contagion. State-backed banks in China and
India will do as directed by politicians. But they are already labouring
under large bad debts.
Global business
may need a giant “bridging loan” to get through a tough few months. And
governments may need to intervene to make it happen: by flooding credit
markets with liquidity; by cutting taxes to get cash to companies; and
by prodding banks to lend and show forbearance. The world’s financial
system has not yet become a source of contagion in its own right. But
neither has it shown it can spontaneously help firms and households
absorb a nasty but transitory shock.■
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