Lesley Meall 3 Oct 2019 04:54pm

Corporate debt: can markets absorb refinancing?

Corporate debt is piling up. Lesley Meall takes a closer look, considers the potential impact, and explores whether the markets can absorb refinancing

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Tick, tock. Tick, tock. Listen carefully, and you may hear the sound of a ticking debt bomb. The world is borrowing much more than it is producing: during the first quarter of 2019, global debt levels rose by $3trn to $246.5trn, almost 320% of global economic output, according to figures from the Institute of International Finance (IIF), a global trade group of financial institutions. Size isn’t everything, but some aspects of this rising debt trend could pose significant risks to the global financial system and the world economy.

It’s not that debt is intrinsically bad: borrowing can make economies stronger by enabling businesses to invest in growth and improve productivity, or by helping governments to fund projects to enhance growth and attract investment. The devil is in the detail. When this $246.5trn global debt is disaggregated into debt for households, financial corporates, non-financial corporates, governments, mature markets and emerging markets, it becomes apparent that some categories are much riskier than others and could quickly turn bad.

Sudden swings

“High and rising debt levels leave corporates and sovereigns more exposed to sudden swings in global risk sentiment,” says Emre Tiftek, deputy director of global policy initiatives at the IIF. Going forward, market sentiment and risk appetite could shift rapidly in response to developments around matters such as: the trade war between the United States and China (and the possibility of a currency war), Brexit, slowing global trade growth, and interest rate rises – any of which could prove problematic for some corporates and investors. Central bank responses to the 2008 financial crisis created a decade of low interest rates and these have encouraged corporates to take on new debt.

Corporate bond markets have become an important source of funding for non-financial companies and according to the OECD, global outstanding debt in the form of corporate bonds issued by non-financial companies has hit record levels, reaching almost $13trn at the end of 2018. That’s twice the amount in real terms that was outstanding before the crisis. Quality and rate of growth are also significant. In May 2019, Sir Jon Cunliffe, deputy governor for financial stability at the Bank of England, told an audience of senior finance professionals: “Research suggests that it is the growth rate of debt rather than its actual level that is the leading indicator of financial crises.” He then went on to note that in advanced economies, while debt has “grown very slowly” in the financial sector following the 2008 financial crisis, the story is “more mixed” when it comes to corporate debt as a whole.

Debt dynamics

“It has not grown much overall over the past five years. But within that, over the past three years its growth rate has accelerated in some countries – particularly the US and France,” says Cunliffe. The riskiness of this corporate debt has also increased. “The proportion of leveraged lending and lower grade corporate bonds has risen rapidly. In the UK and US there is a larger tail of highly indebted companies than before the crisis,” he says. Each country has its own debt dynamics, but there are some common causes for concern. For example, a rise in leveraged (non investment-grade) loans. Simon Macadam, global economist at Capital Economics, says: “In the US, the share of leveraged loans with no requirements for borrowers to meet regular financial tests, such as maximum leverage and minimum interest coverage rations, has risen from around a quarter in 2007 to around 80% at the end of 2018. In the UK, the share has surged to 80% from close to zero in 2010. As a result, leveraged loans have been issued by more indebted companies.”

“Rising sub-investment-grade bond issuance is worrying, because it is occurring at a time when the price of credit has been falling and these bonds have been seen as less risky by investors, when they are risky,” says Trevor Williams, former chief economist at Lloyds Bank Commercial Banking and visiting professor at the University of Derby. He sees the US situation as particularly bad. “It’s reminiscent of the illusion that led to the 2008 crisis,” says Williams. The rise in fixed income securities issued by companies with poor credit ratings may not bode well.

Leveraged lending

In an economic downturn, these businesses could face severe financial stress or insolvency. US central bank the Federal Reserve has been ramping up warnings on historically high levels of business debt, concentrations of debt growth among the riskiest firms and the risks to those firms and their creditors. In its May 2019 financial stability report, however, it also noted low default rates in the booming US economy and pointed out that the leveraged lending market is much smaller than the mortgage sector that almost brought down the financial system in 2008. The International Monetary Fund (IMF) noted in its April 2019 global financial stability report that vulnerabilities in the world’s households and financial sectors are much lower than at the time of the financial crisis, but it also noted a “weak tail” of companies with poor prospects.

“There are growing signs that this credit cycle may be maturing and risks of global slowdown are rising. The most highly indebted companies could be vulnerable to such a shock,” said Tobias Adrian, financial counsellor of the IMF. The IMF also noted that levels of borrowing are continuing to rise even as profitability is falling. “Profitability of companies is interesting,” says Williams. “In the UK, something like a third of listed companies make 80% of the profits and the rest make the rest. So the tail is worryingly long.” And at the end of this tail sits the preponderance of the sort of debt that can’t be repaid unless interest rates stay low – but that’s not the only problem with it. “This kind of debt sucks profitability away from profitable companies,” says Williams. “Many unproductive businesses have been able to stumble on in recent times, generating just enough profit to continue trading but without the innovation, dynamism or investment necessary to sustain bottom line growth,” adds Yael Selfin, chief econo mist at KPMG in the UK. The firm’s recent analysis of the last three annual accounts of FTSE and AIM-listed UK companies found up to 8% so-called ‘zombie’ firms – limiting domestic productivity growth and threatening to exacerbate the impact of any future economic downturn.

Market exposure

Concentration of zombie companies – those under sustained financial strain – is highest in the UK energy, automotive and utilities sectors, but they also threaten the wider economy, warns Selfin, regardless of the post-Brexit environment. “If interest rates rise further, highly leveraged businesses may soon find that borrowing will become more difficult to repay and if the economy continues to stutter, these businesses will be left especially vulnerable to adverse market forces or a tightening of liquidity – as will the lenders they rely on,” he says. Those lenders are more of a mixed bag than they were back in 2008. “The growth of market-based finance has been one of the major changes of the post crisis financial landscape,” says Cunliffe, noting that assets under management globally now total $184trn as opposed to $100trn 10 years ago. “The growth in corporate borrowing over the same period has largely come though the marketbased channel, rather than banks,” he explains, as has an increase in net external borrowing by emerging markets.

Leveraged loans originate in the banking system, but it is much less exposed than it used to be; painful deleveraging of the financial sector during and after the crisis made it more risk averse. This has been reinforced by higher levels of capital that banks are required to hold against losses. “Much of the exposure appears to have been passed on to marketbased investors such as investment funds, insurance companies and pension funds,” says Cunliffe. Either directly, or in the form of collateralised loan obligations (CLOs). Leveraged loans are routinely packaged into CLOs, a kind of collateralised debt obligation (CDO). Loans are sliced and diced into tranches, with different levels of credit risk, then sold to investors. Let’s not forget that a decline in the value of CDOs’ underlying commodities, mainly mortgages, helped to kick-off the 2008 financial crisis. “You don’t always know what is bundled into CLOs. But you have to know what’s in a CLO or you don’t know what can go wrong,” says Williams. So strains in underlying corporate loans could deliver some unexpected losses.

Balance of risk

Nonetheless, Cunliffe thinks that the development of market-based finance “in and of itself”, probably increases the resilience of the financial system because it provides an alternative channel of credit – that uses leverage less than the banking channel. “Investors using the market-based channel have a claim on the value of their investments, not the nominal amount they invested, and their claims should therefore be able to adjust to losses more smoothly,” he explains. Although there are still risks in the market-based channel. “Market-based finance often involves liquidity and maturity transformation and can be subject to run risk,” says Cunliffe, and one of the developments over the past decade has been an expansion of the investment fund component of market finance into riskier and less liquid areas.

“We know much less about how this channel of finance will behave under stress say, following the loss of confidence in an asset class such as high yield corporate debt and leveraged loans,” he says, noting the potential for relatively small changes to have a big impact. High yield corporate bonds and leveraged loans make up 15% of advanced economy corporate debt, but a sharp correction in a small asset class can have major repercussions: stock of US subprime mortgage was £1.1trn in 2006, just 13% of total US mortgages. “There are many differences between leveraged loans and associated CDOs and subprime,” says Cunliffe. “But it is now a priority for the international regulatory community to understand better how this market might behave under stress and who is holding the risk.” The clock is ticking

The right kind of debt

Concerns about rising and increasingly risky corporate debt aside, business debt is not intrinsically a bad thing. “Debt is a useful tool for companies. It’s a legitimate form of financing and a fundamental tool to allow businesses to do deals and to help a business grow,” says Katerina Joannou, manager, capital markets policy, ICAEW. However, it is important for companies to get professional advice on whether debt is the right source of finance for what they want to achieve. “There is an important role for the profession in advising businesses on what the right capital structure is,” Joannou says.

ICAEW’s Corporate Finance Faculty provides best practice guidelines and valuable insights in its Debt for deals publication. Debt for deals describes the debt market in the UK and highlights significant changes since the global financial crisis of 2008-2012, looking at the increasingly diverse range of available options and highlighting factors to be considered by companies (and advisers) that want to secure the best funding package for their needs. It also sets out the principal flows involved in the application and lending decision process. The online version of ICAEW’s Business Finance Guide also offers information on funding options potentially available at every stage of a business journey.