While people were quick in deriving parallels from the past recessions when the spread between 2 year and 5 year treasury notes went negative, the first inversion of the yield curve since 2007, there doesn’t seem to be any unanimous consensus on what could lead to a next recession. It’s been an unprecedented turn of events that has left the market pondering about whether there will be a recession or not. On one hand, we have these signs of economic contraction with long term yields getting lower than short term yields posing a fundamental risk to financial institutions, on the other, strong GDP numbers, lowest level of unemployment and positive inflation give an all-together different picture. While it's rational to think that economy won’t grow as much as it has in the past year, saying that there will be a recession next year is a little far fetched. Public reaction towards wide spread dissemination of a possible recession has led the market to one of the sharpest declines in the recent history. Trade war with China, uncertainty over Brexit, central bank’s feud with government in South East Asia, Italy debt crises and upcoming elections; political vagueness seems to be contributing towards the long term pessimistic view on the economy more than macroeconomic indicators.
Growing concerns over these harrowing events can’t be shrugged off, however, one major threat that’s certainly looming over US economy is high level of corporate debt. In the past years, strong economic backdrop and years of quantitative easing have prompted several companies to take on cheap debt but with Fed continually raising rates, it has become expensive for firms to service existing debts. In a rising interest rates environment, bonds loose value, thus requiring companies to roll over debt at higher yields. Dodd Frank Act in the wake of 2008 financial crises required banks to maintain a minimum of 10% capital in order to have a cushion against unfavorable conditions. It made banks reluctant to provide risky loans and invest exorbitantly in risky assets. This gave rise to a new wave of non-bank lenders that provide high interest loans to individuals, corporations and sell these loans to investors looking for high return portfolio. Financial intermediaries like investment banks, commercial banks and insurance companies started buying these high yield securities in order to stay competitive. Since these are non-bank private organizations, they don’t come under the purview of Federal Reserve. With banks turning down loans to companies with low credit ratings, companies started exploring other options in peer to peer, payday and syndicate lending. Wonder who invest in these securities, financial intermediaries.
The market of these non-bank lenders grew so much that it has started posing a risk of financial breakdown if multitude of borrowers default. Companies have accumulated billions of debt in the previous years and these high yield and leveraged debt have remained a solid investment for banks, insurance companies and pension funds. In the light of recent tightening of monetary policy, there is a risk of companies failing to meet their obligations during the next the downturn. Companies are already sitting on a bigger debt piles than just before the last two downturns. If these BBB bonds get downgraded by rating agencies, there could be a contagion effect when companies start defaulting on their payments on account of high cost and reduced margins.
US corporations have so far steadfastly weathered the raising interest rates cost because most of them have locked in low cost of debt during the nearly zero interest rates environment after the recession. But with most of their debt moving towards maturity in coming years, it looks like it’s going to be difficult for companies to refinance debt in the period of increasing rates and sluggish economy.
Looming Maturity
Debt is very unforgiving. And yet in the last decade the debt has piled up, especially at companies that bulked up through mergers and acquisitions. Campbell Soup borrowed more than $6 billion to buy Snyder’s-Lance, the potato chip and pretzel maker, and the company’s debt is now more than five times its cash flow. After Keurig Green Mountain and the Dr Pepper Snapple Group merged, the combined company’s debt reached $17 billion, nearly six times its cash flow. Bayer now has around $40 billion of net debt outstanding after its acquisition of Monsanto; CVS Health issued $40 billion of bonds to help pay for Aetna; and Sherwin-Williams sold $6 billion of debt when it bought Valspar. By one estimate, IBM will issue around $25 billion in new debt to complete its $34 billion acquisition of the software company Red Hat.
Percentage of BBB bonds
“On Dec. 14, copy-machine behemoth Xerox lost its investment-grade rating from Moody’s Investors Service, cited a steep rise in debt multiples”
Last month in India, conglomerate, Infrastructure Leasing and Financial Servicesdefaulted on billions of its obligation which led to government bailing out the company preventing the domino effect. However, it couldn’t stop stock prices of numerous big banks and insurance companies from falling steeply, SBI Life insurance, Yes Bank, Dewan housing to name a few.
Stakes are definitely high in December 18 -19 Fed meeting. It might be the toughest decision for Fed to make in the recent years. While raising interest rates could result in a negative spread between benchmark 10 year treasury and 2 year treasury bond and increase the possibility of potential defaults by debt ridden companies, not raising rates can give wrong signals to the people showing that Fed, too, may not be so optimistic about the economy.
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