Picture: 123RF/PAVEL IGNATOV
Picture: 123RF/PAVEL IGNATOV

The past decade has been good for corporate bonds: interest rates have been kept low by a steady economic recovery (the second longest on record in the post-World War 2 era), and inflation has been muted.

More importantly, the impact of enormous quantitative easing (estimated at more than $12-trillion) by the world’s largest central banks since 2008 has depressed rates.

This has forced investors to hold riskier assets — such as corporate bonds — to secure a reasonable yield. Now, quantitative easing is abating: the US Federal Reserve is reducing its balance sheet and the European Central Bank is likely to do the same from 2019.

The environment for corporate bonds remains benign with abundant liquidity, but we are worried we may face a nasty credit squeeze in the US. While we don’t believe that market tops or bottoms can be forecast in advance, we can take the temperature of a market and determine if it is running hot (high expectations accompanied by high valuations) or cold (the converse). In our view, there are many signs that the US corporate credit market is running extremely hot.

A recent HSBC report, “US Corporate Leverage: Viewer Discretion Advised”, provides a sobering assessment. The ratio of core corporate debt to GDP is the highest yet, exceeding the pre-global financial crisis peak. The proportion of corporate borrowers rated as “speculative” by Moody’s (67%) is the highest yet.

Within investment-grade debt, the lowest-rated (BBB) tranche comprises about $2.4-trillion — about 50% of total debt and once again the highest yet. A “wall” of US dollar debt will require refinancing over the next five years — $3.9-trillion of investment-grade debt and $1.5-trillion of high-yield debt. This also includes non-US companies that have issued US dollar debt.

There has been enormous issuance of lower-rated credit, comprising both US corporate high-yield debt ($1.2-trillion) and leveraged loans ($1.1-trillion), both now more than double pre-global financial crisis peaks.

Corporate bond markets depend on primary dealers (large investment banks) to “make a market” by providing bids and offers to institutions that want to trade. This results in the primary dealers holding inventory of these bonds. An unintended consequence of the rules introduced for banks to curb proprietary trading after the global financial crisis is that the carrying costs of the corporate bond inventories required to facilitate market-making have become very expensive. US primary dealers’ debt inventories have consequently declined from more than $225bn in 2007 (about 7.5% of issuance) to about $30bn nowadays (only 0.5% of issuance).

Refined process

The liquidity risk presented by the effective withdrawal of primary dealers from their market-making function will only become visible in the next period of credit market stress. This could be magnified dramatically given that a substantial proportion of corporate debt (about 20%) is now owned by retail investors via mutual funds and exchange-traded funds that, in theory, have immediate liquidity.

We have revisited all our geared buy list stocks and refined our process when evaluating potential new positions. This encompasses both traditional metrics to evaluate the amount of leverage, and an analysis of each company’s economic suitability for gearing in the first place.

As some companies are well suited to leverage, the debt size may be a misleading measure in isolation. Businesses with long-life assets, stable revenues and wide cash operating margins — such as real estate companies — can typically handle gearing.

A poorly structured balance sheet can however cause even a business that is economically well suited to gearing battle during periods of credit market stress. Shareholders in UK-listed property group Liberty International (now renamed Intu) were enormously diluted by a forced capital raise in a stressed credit market during 2008-09. The net asset value per share declined from more than 1,000p to about 300p within a year.

Clearly, having good assets is not enough. The key to a robust balance sheet is the debt structure. So, what are the hallmarks of a well-structured balance sheet?

  • Careful management of the “maturity window”. Debt becoming due within three years is said to be “in the window”. It is crucial that a company’s available liquidity easily more than covers these debt maturities. We look for evidence of redeeming large bullets of debt rolling into the window early, and undrawn revolving debt facilities that are conservatively sized (larger than needed) and regularly renewed to move expiry dates beyond the window.
  • A conservative debt issuance profile. We prefer companies with long weighted-average debt maturities and a high proportion of fixed-rate funding — we want companies to have taken advantage of the historically benign funding environment. We look for debt currency-matched to revenues (rather than just issued in the currency where yields are lowest) and a well-spread maturity ladder with no individual years dominating issuance.
  • Covenant flexibility. Most debt facilities come with rules or restrictions called covenants that the borrower must adhere to. Where covenants are in place, we look for all covenants having ample headroom and being unrestrictive when stress-tested for changes in profits, asset values and interest rates. Funding should be obtained from a variety of sources — for example banks and public markets; asset-specific, non-recourse debt; and unsecured company-level debt. The level of asset-specific financing should be restrained so that no group or cross-asset covenants are required.

A resilient balance sheet can easily weather an extended period of credit market stress. Maturing debt can be redeemed from existing liquidity and even with a decline in cash flows and asset values, there is no realistic risk of a covenant breach.

• Cousins is head of research at PSG Asset Management