Picking up pennies (in front of steamrollers)

Peter Warburton - 22 February 2017

“Investors rush to junk bonds in big bet on Trump pledges” ran the headline in the London edition of the Financial Times on 9 February. Just try taking those pledges on economic growth, lower tax burdens and less regulation to the bank. As we have warned since last October – when we held an investor seminar in London – the global credit cycle is turning and the incidence of bond default and debt delinquency is rising. A US telecommunications company, Avaya Inc., filed for chapter 11 bankruptcy last month involving over US$6bn of debt, the largest bankruptcy for years.

About US$40bn of junk refinancing has occurred in the first few weeks of 2017, the fastest early-year pace since 2013. It is no surprise that companies with high-yield debt ratings are anxious to term out their financings, typically to around 2019-20. The game is up! Much more of this newly refinanced debt will default, because much more of it constitutes financial engineering rather the financing of potentially lucrative, growth-enhancing activities. Those investors piling into B-rated and even CCC-rated corporate debt at this very mature stage of the credit cycle are picking up pennies in front of the proverbial steamroller.

As shown in the charts in our January Global Credit Update, tight junk-bond credit spreads are the sideshows, not the main event in the credit circus. Slowing global private sector credit growth, tightening bank and non-bank lending standards, steepening yield curves, rising auto loan and credit card delinquencies and signs of greater divergence in corporate financial health are the warnings to heed. The re-pricing of US benchmark bonds since last summer has had a marked impact on the pace of US mortgage refinancing already, as portrayed in figure 1.

The era of ultra-cheap credit is coming to an end, not because central banks are taking timely evasive action, but because of the excesses and absurdities that it has spawned. The slowing pace of US corporate buybacks is not a sign that funds are being redirected towards fixed investment to enhance future productivity and economic growth. It is a telling symptom of tightening financial conditions in an economy where unit labour cost inflation is picking up and the productivity of the capital stock is falling. It is high time that institutional investors abandoned sub-prime corporate and sovereign debt.

Figure 1

Data sources: Thomson Reuters Datastream

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