22-Feb-2020 Chris Joye reminds us that the next global financial crisis likely to be centred on sub-prime corporate debt:
As this column has repeatedly warned, credit spreads on high-yield, or sub-investment grade (aka "junk") corporate bonds, and more robustly rated “investment-grade” corporate debt in the US have slumped to below the absurdly low levels last evidenced in the heady days of 2007. Concurrently, there has been a surge in riskier corporate lending. Writing in a 2019 edition of The Journal of Fixed Income, legendary debt investor Daniel Zwirn and two academic co-authors conclude that “today’s BBB corporate bond is yesterday’s [junk] BB”. “There has been an alarming increase in the number of BBB bonds issued after 2014,” they write. “The BBB market is not only more crowded but, disconcertingly, it is also riskier (on a comparable basis) by virtue of having more leverage, as measured by debt divided by EBITDA.” Compared with average BBB leverage of two times during the 2008 crisis, Zwirn et al show this metric had crept up to 3.2 times by 2018. They further cite Morgan Stanley research that finds that if companies were rated on leverage alone, “over a quarter of the investment-grade [bond] market would have a high-yield [or junk] rating”. This has coincided with a boom in riskier private debt and “leverage loan” lending to mid-market businesses that cannot access the cheaper investment-grade or bank-intermediated sectors. Drawing parallels with the 2008 cataclysm, Zwirn et al argue that “a leverage loan and a subprime mortgage share common features”. “A subprime mortgage is created for individuals with poor credit in the same way that a leveraged loan is created for corporations with poor credit ratings."
“The greatest danger leverage poses is its ability to amplify otherwise small levels of uneasiness in the system, which can trigger a systematic shock. This happened in the subprime market in the past and it can happen in the corporate credit market now. With economic downturns occurring on a dependable cycle, it is only a matter of time before we witness and suffer the consequences of an overleveraged credit market implosion.”
Andrew Leigh, arguably Australia’s smartest politician, touched on similar themes in an important speech during the week where he made the case that “the Australian economy is in a deep-seated malaise”.
Leigh referenced research by the Commonwealth Treasury’s Dan Andrews that confirms our own quantitative analysis documenting the rise of “zombie” companies in Australia. Zombies are defined as those firms committing more than 100 per cent of their earnings to repay the interest on their debts. Our latest numbers suggest that about 15 per cent of all ASX companies meet this criteria, up from less than 10 per cent in 2010.