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John Kinsellagh
John Kinsellagh
Articles (190) 

Fault Lines Appearing in Lower-Rated Corporate Bond Market

Downgrades and default rates could swell in the next credit cycle downturn

October 23, 2019 | About:

While riskier assets such as stocks have shown gains over the past year, the low end of the corporate debt market has recently faced some challenges that are cause for concern.

Changes in the structure of the economy have had a detrimental effect on a number of companies. Increasing consumer demand for wireless phones and high-speed internet has forced one company, Windstream Holdings Inc. (WIMNQ), into bankruptcy and another, Frontier Communications Corp. (NASDAQ:FTR), into restructuring/reorganization discussions with its creditors.

Other business sectors, most notably coal mining companies, have been adversely impacted by the conversion to cheaper, cleaner natural gas and other renewable energy sources. No less than seven coal companies have filed for Chapter 11 bankruptcy protection over the past year. Even though the U.S. is the world’s largest petroleum exporter, a number of companies involved in tertiary services, as well as some financially overstretched fracking companies, have hit rough patches due to persistent low commodity prices.

The pressure affecting the high-yield corporate bond market can be explained, in part, due to recurring problems in the energy sector, which constitutes the largest portion of the low-grade market. However, the declining quality and credit exposure trends are similar for other areas in the speculative-grade debt market, including health care and technology.

All the potentially deleterious factors noted above, in conjunction, have caused yields to rise on the lower-rated sector. The “risk premium” that investors demand above the London interbank offered index rate has been increasing since June for corporate loans rated triple-C, while remaining stable for higher rated single-B and double-B issues.

One of the largest concerns among investors is that should cracks begin to appear at the lower rungs of the corporate debt market, it could spread quickly to other, larger asset groups. Investors aren’t the only ones worried; Federal Reserve Chairman Jerome Powell has repeatedly expressed concerns over the past two years about the exposure of highly-leveraged corporations to these increased rates should an economic downturn appear on the horizon.

The ratings firms have issued alarms about the weakest corporate borrowers in the lowest rated sections. Standard & Poor’s (S&P) maintains a “weakest link” measure for at-risk companies (corporations rated B-minus or lower) included on their negative outlook list. As a measure of the increasing risk, in a report last week, S&P Global Ratings said its list of “weakest link” companies reached a 10-year high in September of 26, the most since November 2009, when the financial crisis resulted in defaults climbing to 10.5% globally for speculative-grade companies.

Another worrisome sign is that the number of corporate loans downgraded by S&P Global Ratings has outpaced upgrades during the past three months by the largest amount in a decade.

Although few analysts believe that the $1.2. trillion “junk bond” market is at imminent crisis levels, the number of entrants to the “weakest link category” is causing some consternation, as a slight economic downturn or a modest increase in rates could send the sector tumbling, with adverse ramifications for the rest of the market.

Consider the following sobering statistics:

In the report, S&P analyst Nicole Serino wrote, “The default rate of weakest links is nearly eight times greater than that of the broader speculative-grade (rated BB+ or lower) segment, and the weakest link tally may signify higher default rates ahead.” Matt Forester, chief investment officer at BNY Mellon’s Lockwood Advisors, noted the following in an interview: “Credit quality for the average corporate issuer has continued to deteriorate. I think good portfolio managers are very much concerned about the leverage and overall quality of corporate financing.”

As an additional sign of foreboding, Moody’s Investors Service on Thursday said that while U.S. corporate defaults were still a low 3.2% among speculative-grade companies in September, it warned that downgrades and defaults could climb when the credit cycle turns. Should the credit cycle turn, defaults in the lower-rated sector could “easily exceed the last cycle” peak of 14%. Conditions would largely deteriorate speedily because of the record volume of the firms with B3-rated debt that could drop dangerously down into the Caa tier.

Those investors seeking the highest fixed-income returns in a relatively low-yielding corporate bond environment should be mindful of these incipient risks present in the low speculative end of the market.

Disclosure: I have no position in any of the securities referenced in this article.

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About the author:

John Kinsellagh
John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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