What the new debt paradigm means for investors

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What the new debt paradigm means for investors
Borrowing costs for investment-grade corporates have soared in the past year. Photo: Matt Cardy/Getty Images

Borrowing costs for investment-grade corporates have ballooned in the past 12 months or so. In the US, the five-year BBB corporate bond yield is back to more than 5 per cent, a level not seen since 2009.

On average it was below 2.75 per cent between 2012 and 2018, and below 1.6 per cent in 2020-21. This is a major change in the environment for both companies and individuals.

Markets are still working through all the implications of a higher cost of capital. We describe them as the "three Ds": derating, downgrades, and debt refinancing.

Derating first. The most obvious example of risk here is in the sector that has been the most beloved in recent years: technology.

After a brief spell out of favour, the tech sector has rallied strongly this year to again become the darling of investors.

In our view, there is little fundamental logic to the rally. Problems in the banking sector on both sides of the Atlantic have sent investors running back to the winners of the past decade in search of familiarity, and the safety of companies with net cash on the balance sheet.

The real lesson of the crisis in mid-sized US banks is the reminder that investors need to be very wary of assets purchased or built with, or business models reliant on, unsustainably low interest rates and low cost of capital.

We would caution that derating risk is not dead, just sleeping. In the context of normalising bond yields, tech stocks still look expensive to us. Tina (the acronym for "There is no alternative") is no more. There is an alternative.

Downgrades, the second D, should be less of a surprise, but no less unwelcome, as a recession in the US (at the very least) looms large.

The minutes of the March meeting of the Federal Reserve revealed concerns among senior officials over the potential for the turbulence in the banking sector to end up tilting the US economy into a recession before the end of the year.

Investors need to remember how earnings in many parts of the market are still well above historic averages, boosted by the exceptional conditions of 2020 and 2021. The process of normalising earnings expectations will take a while and could be uncomfortable for some.

This brings us to the third D: debt refinancing. Last but by no means least, in such precarious markets, a company’s ability to refinance its debt can be an incredibly useful indicator of how well it is likely to ride out the storm.