Fueled by a decade of massive borrowing and a prolonged climate of low interest rates, the investment-grade corporate bond market now sits atop a precipice. A worse-than-anticipated economic downturn or a more aggressive interest rate policy by the Federal Reserve could trigger a conflagration that would ripple through the bond and stock markets.
A review on the amount of corporate debt currently outstanding will prove edifying for those investors heavily weighted in these fixed-income vehicles.
The total dollar amount of the lowest-quality investment-grade corporate debt over the past decade, defined as BBB-rated, slightly above junk bond status, is $3 trillion. This represents an increase over the approximately $700 billion outstanding in 2008. A significant amount of corporate debt issued recently has been fueled by the merger and acquisitions craze over the past two years, as well as for funding share buybacks.
Other market indicators are similarly alarming.
Triple B-rated corporate bonds represent almost 50% of all outstanding investment-grade debt. There is a misconception among investors who consider all investment-grade debt as low risk, unaware that BBB-rated bonds now make up approximately half of the total $6 trillion investment-grade market. By comparison, during the financial crisis in 2008, these comparable rated bonds accounted for less than a third of the total.
Numerous risks abound for the BBB grade issuers. For many companies, maintenance of existing ratings for its current low grade debt are contingent upon implementation of deleveraging plans. Should assumptions about free cash flow prove erroneous, however, many companies could drop down a notch to junk bond status, with all the attendant risks associated with a downgrade.
AT&T (T, Financial) assumed $190 billion in debt to finance its purchase of Time Warner; Disney (DIS, Financial) took on additional debt for its acquisition of Twenty-First Century Fox's (FOXA, Financial) studios. Even though AT&T claims that the additional debt won’t be a problem, the extra $190 billion in debt incurred for the purchase of both Time Warner and DirectTV has impacted revenue and operating margins are struggling. This doesn’t even address the problems associated with the difficulty of a legacy media company trying to compete in a 21st century digital streaming market, which is now dominated by Netflix (NFLX, Financial). The same problems apply to Disney.
An additional danger is that the interest coverage for many BBB issuers has dramatically worsened. Since 2008, leverage, as measured by debt divided by annual average earnings before interest, taxes, depreciation and amortization, has increased substantially for BBB issuers. The average is now 3.2 times EBITDA, compared with 2.1 in 2007. According to Stephanie Pomboy, head of economic research firm MacroMavens, an inordinately high number of companies, 37%, have debt that is more than five times or more of their EBITA.
It is important to note that much of the trillion-dollar investment-grade debt was issued in a zero-interest rate environment that lasted for over a decade. The Federal Reserve has only recently started to creep rates upward. The heady days of quantitative easing are over.
Damage from an upheaval in the low-grade debt market would not be confined to the investment-grade and junk markets. A selloff in the junk bond market would impact the smaller-yield, higher-rated issues by way of price drops as a new supply of debt would be infused into the bond market.
Although some may take comfort in the fact that corporate America has a $2.1 trillion cash stockpile to cushion any debt problems that may arise, that should be tempered by the fact that $1.2 trillion of that total is held by only 25 companies, including Apple (AAPL, Financial) and Microsoft (MSFT, Financial).
From another perspective, the picture only worsens. According to Standard& Poor’s Global Ratings, removing those 25 companies from the total reveals that approximately 450 companies with investment-grade debt had cash-to-debt ratios more akin to those of speculative-grade issuers—such as junk bonds—than with investment-grade companies in the top 1%.
That is a sobering picture should an economic downturn occur in an environment of increasing interest rates.
Investors should be mindful of these warning signs and adjust their holdings of BBB issues accordingly.
Disclosure: I have no positions in any of the securities referenced in this article
