Corporate debt

We entered 2020 concerned about the quantity and quality of corporate debt, and companies have taken out an excessive amount of debt to maintain liquidity. But the Fed threw the corporate debt market a lifeline and rates are lower than ever.

Contributor

Rhea Thomas, Senior Economist for Wilmington Trust Investment Advisors, Inc. View bio

Contributor

Randy Vogel, CFA, Director of Taxable Research and Senior Portfolio Manager for Wilmington Trust Investment Advisors, Inc. View bio

Pre-Pandemic credit markets
were vulnerable to flare-up

Our 2019 CMF warned of the rising risk of a corporate credit crisis due to the nature of debt growth post the financial crisis. An unexpected economic shock could impair companies’ abilities to repay debt. Credit spreads1 might spike in the face of ratings downgrades, as investors demand additional compensation to hold corporate debt. Rising borrowing costs would make it harder for firms to repay debt, potentially sparking a broader credit crisis.

January
2009
December 31, 2019
September 30, 2020

Each circle represents approximately $100B in debt

In the aftermath of the financial crisis, a prolonged period of low interest rates fueled a build-up of corporate debt. This was particularly worrisome because of concentrated growth in the lowest-quality (BBB) category of investment-grade debt (+315% from January 2009 to December 2019).

Quality ratings and issuer “grades.”

Quality ratings are used to evaluate the likelihood of default by a bond issuer. Independent rating agencies, such as Moody's Investors Service and Standard & Poor’s, analyze the financial strength of each bond's issuer. Ratings range from Aaa or AAA (highest quality) to C or D (lowest quality). Bonds rated Baa3 or BBB and better are considered investment grade. Bonds rated Ba1 or BB and below are speculative grade.

Sources: FTSE Fixed Income LLC, Morgan Stanley, Bloomberg, WTIA.

Fed to the rescue—Crisis averted

The Fed’s unprecedented actions were crucial in preventing a financial market crisis. The Corporate Credit Facility, announced in a press release from the Fed on March 23, 2020, allowed the central bank to purchase corporate debt for the first time in history, in both primary (new issue) and secondary markets. It was later expanded to cover fallen angel debt that had still been rated investment grade as of March 22.

Borrowing Costs Low

Fed action prevented corporate credit spreads from spiking to financial crisis highs. They have now eased below their longer-term average, helping to keep borrowing costs low for companies.

Investment-grade credit option-adjusted spread
In percentages
Chart showing that borrowing costs are low at about 1.5%, after a spike to nearly 4% on March 23.

Sources: Macrobond, Bank of America.
Data as of September 30, 2020.

Borrowing Costs Low

Fed action prevented corporate credit spreads from spiking to financial crisis highs. They have now eased below their longer-term average, helping to keep borrowing costs low for companies.

Debt Issuance Surged

Companies took full advantage of low borrowing costs and increased liquidity provided by the Fed’s actions. Firms have largely kept the funds raised via debt issuance in cash, bolstering balance sheets and further insulating them from ratings downgrades.

Investment-grade corporate issuance
Chart showing that debt issuance is up 41% from 2019, at just over 1,800.

Source: Barclays.
Data as of September 30, 2020.

Debt Issuance Surged

Companies took full advantage of low borrowing costs and increased liquidity provided by the Fed’s actions. Firms have largely kept the funds raised via debt issuance in cash, bolstering balance sheets and further insulating them from ratings downgrades.

Default rates moderate, for now

The current U.S. speculative-grade default rate sits at 8.7% as of August 2020, relative to 4.5% pre-pandemic, according to Moody’s.2 This is compared to the 14.7% peak rate in November 2009 during the financial crisis, and an average of 4.5% going back to July 2001.

Corporate leverage more elevated than ever

The Fed put out the credit market fire before it spread more broadly, but the kindling may merely be building for the next potential flare-up. The health of the corporate credit market will depend on whether corporates use the cash raised from their increased debt issuance to pay down debt as the economy recovers and cash flows improve. If not, this increased corporate leverage could leave credit markets vulnerable once again.

Nonfinancial corporate debt
Percentage of nominal GDP

Sources: Federal Reserve, Macrobond.
As of September 30, 2020.

Corporate debt as a percent of GDP had been steadily rising since 2011, and had returned to financial crisis highs prior to the pandemic. It’s now at an all-time high, spiking from 46% in 4Q 2019 in just two quarters to 56% as of 2Q 2020, due to an unprecedented surge in debt issuance and lower GDP due to the recession.

CFA® Institute marks are trademarks owned by the Chartered Financial Analyst® Institute
1. The corporate spread is the additional yield offered by a corporate bond above that of a Treasury security to compensate for the risk that a company may not be able to repay its debt
2. Moody’s August 2020 Default Report

 

Wilmington Trust’s Director of Taxable Credit Research and Senior Portfolio Manager Randy Vogel, CFA, shares the pandemic’s impact on credit quality, the Fed’s supportive actions, and the role of investment-grade debt in client portfolios.

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