Corporate debt as a share of gross domestic product has risen dramatically over the past decade and, with it, leverage has increased and credit quality declined. Many investors are left wondering if credit markets could be the harbinger of the next economic downturn.
There are five key post-crisis changes to the most transparent sector of corporate debt – the public debt market – that investors should understand.
1. The corporate bond market is growing fast
The global debt market has changed dramatically over the past 12 years. In 2006, structured products accounted for 45 per cent of all issued debt.
After the global financial crisis, the fallout from the sub-prime mortgage market, a tighter regulatory framework and an increase in financial institution risk awareness led to a 50 per cent decline in the issuance of structural products.
Corporate bond issuance rose to fill the gap, leading to an evolution in the structure of debt markets, and, since 2009, corporate bonds have accounted for 57 per cent of all issuance.
The combination of low borrowing costs and yield-hungry investors (27 per cent of global government debt yields less than 0 per cent) has created the perfect environment for rises in both demand and supply.
2. The quality of investment grade debt is in decline
Investment grade corporate bonds are like cuts of beef: at the top end, there is the tender filet mignon (AAA-rated bonds) and, at the bottom, the tougher rump steak (BAA-rated bonds).
When investors buy investment grade bonds, they may think they are getting the prime cuts but end up with the rump without being compensated for this.
With low borrowing costs and investors desperate for yield, companies rationally altered their capital structures or financing methods by issuing debt.
However, rising leverage and a potentially weaker credit position have created an overall decline in the quality of corporate bond indices.
Between December 2008 and January 2019, the share of the lowest-ranked bonds in global investment grade corporate bond indices has doubled from 24 per cent to 50 per cent.
The deterioration in index quality is a worrying trend, but there are mitigating factors when assessing the overall level of risk.
For example, many companies have used the easy funding environment to refinance existing debt at more favourable rates and extend their debt maturity profile.
As a result, if rates start to rise and financial conditions tighten, the pressure on funding costs will be felt only gradually.
Beyond this, credit is often thought of as a non-recessionary asset, in that it offers low levels of return and income so long as the economic outlook is benign.
3. Lenders have less protection
In 2018, an estimated 87 per cent of leveraged loan issuance was considered to have a lower-than-normal level of protection for bond holders.
These types of loans are known as ‘covenant lite’ where investors do not require borrowers to commit to maintain certain financial ratios.
Growth in this market has been driven by a higher level of private equity ownership, and the preference to raise capital with more favourable terms for the lender in the leverage loan market.