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US corporate debt bubble building [ClearOnMoney]
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Commentary

US corporate debt bubble building

1 Jan 2014 by Jim Fickett.

The Financial Times had a good summary, from a recent conference, giving evidence of considerable froth in US corporate debt markets:

To the sceptics, the market is experiencing the kind of frothiness seen before the 2008 financial crisis. This, too, will end in tears, they warn.

Perhaps the foremost of these “credit Cassandras” is Jeremy Stein, the US Federal Reserve governor who warned in February that markets may be overheating. “A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield’,” he said, flicking through slides of warning signals. Since then, those warning signals have flashed ever brighter.

Issuance of syndicated leveraged loans – those made to companies that already carry high debt loads – reached $535.2bn in 2013. That is just shy of the $604.2bn sold in 2007, at the height of the last credit bubble. Meanwhile, loans that come with fewer protections for lenders, known as “covenant-lite”, accounted for almost 60 per cent of loans sold in 2013, compared with a 25 per cent share in 2007.

Sales of “payment-in-kind” notes, which give borrowers an option to repay lenders with more debt reached $11.5bn in 2012 – a post-crisis high.

“There are no bargains in fixed income. We have seen a return to a lot of the practices that made people nervous in 2007 such as PIKs and cov-lite,” says Russ Koesterich, chief investment strategist at BlackRock.

Sales of “junk”, or high-yield, bonds surged to a record in 2013 as companies rushed to refinance and investors snapped up the resulting assets. Issuance of junk bonds rated “triple C” – the lowest designation – jumped to $15.3bn, surpassing the pre-crisis peak.

[See graph below, adapted from the FT, with data from S&P Capital IQ.]

“There are early warning signs of excess in the high-yield bond market with the heavy issuance of triple C rated debt,” says Edward Marrinan, of RBS Securities.

Others cite reasons for optimism. They note that credit “spreads”, or the additional returns investors demand to hold riskier credit assets, are not yet near the historic lows experienced in the run-up to the 2008 crisis. That suggests investors are differentiating between riskier assets and relatively safe securities, such as US government debt.

[This is a stupid argument. Spreads are high because the Fed has forced Treasury yields to unnatural lows. What matters is whether the total yield compensates for the risk. It does not.]

In contrast to 2007, the current average junk bond yield of 5.6 per cent is far higher than the yield on offer from the five-year Treasury note, at a difference of about 423 basis points. In June 2007, this spread had narrowed to a record low of 238 bps.

The argument against a bubble forming in the market at the moment is that overall credit remains abundant, enabling companies to roll over their funding, notes Mr Koesterich. “Companies can still raise money, so there is no financing risk.”

[Just like there was no refinancing risk for mortgages that could not be repaid. For a long time. And then suddenly the money dried up, as it will here.]