The Corporate Debt Binge Is Cooling Rapidly

The third quarter was tough for US corporations. Worse than the prior two quarters. They got waylaid by weak global demand and lack of pricing power. The easiest way to increase revenues and profits is to raise prices, so via inflation, but that strategy isn’t working when consumers don’t have the additional income to pay for higher prices.

Then there’s the “strong dollar.” On Thursday, Draghi evoked more QE and even more negative deposit rates, which eviscerated the euro and made the dollar a heck of a lot stronger. And so many US corporations are now reporting declining revenues.

It isn’t just the energy sector. For the 142 non-energy companies that have reported Q3 earnings so far, revenues dropped 3.0% year-over-year, according to Moody’s Credit Markets Review and Outlook. Operating income of these non-energy companies fell 2.7%. In this environment, companies try to maintain their bottom line by cutting costs.

“Results such as these weigh against expecting much of a pick-up by either hiring activity or capital expenditures,” Moody’s warns gloomily. Both have been dreary recently.

Cheap money is no longer readily available to riskier borrowers. In the third quarter, bond issuance by junk-rated companies plunged 38% from a year ago. Yields rose as the spread between high-yield bonds and Treasuries soared. And in October, according to S&P Capital IQ’s LCD, it has been even worse: just seven junk-bond deals through Thursday, for a measly total of $3.7 billion.

Leveraged loans are in a similar quandary. These loans issued by junk-rated companies, often for special dividends to their private equity owners or for M&A, are so risky for banks that regulators have been cracking down on them for two years. Banks usually sell them, either directly to funds or repackaged as Collateralized Loan Obligations (CLO). But during the Financial Crisis, banks got stuck with them. And now leveraged loan issuance is petering out.

Total high-yield borrowing (junk bonds and leveraged loans combined) plunged 37% in the third quarter from a year ago, according to Moody’s. And for the 12-month period, total issuance is down 29% from the 12-month all-time record in Q4 2013.

But here is the thing: within 15 months of the three prior peaks of total high-yield borrowing – the all-too-familiar periods of Q3 2007, Q4 1999, and Q4 1989 – recessions occurred.

Moody’s tries to assuage our frazzled nerves:

Though it is most premature to predict impending doom for the current recovery, the latest dive by high yield borrowing warns that the current upturn has lost its youthful vigor and with age has become more vulnerable to adverse shocks.

The problem is that this reduction in borrowing by junk-rated companies – including many big players – “is capable of stalling overall spending.”

It didn’t just hit oil-and-gas companies. Worldwide issuance of high-yield corporate bonds plunged 30% in Q3 year-over-year: while issuance by oil-and-gas companies plummeted 83%, issuance by other companies plunged 21.5%.

And there’s another troubling aspect: the deterioration of overall corporate credit ratings. High-grade borrowers (rated A2 or higher) have access to funds even in difficult times, but their number has been shrinking as companies have mucked up their balance sheets by borrowing more for M&A and share repurchases. There is a real cost to financial engineering: downgrades have pushed these companies into lower credit categories.

Through 2011, high-grade companies were the top bond issuers. But now “medium grade” companies (rated A3 or Baa) have become the most prolific bond issuers.

From 1995 through Q2 2012, issuance by high-grade companies was on average nearly double the issuance by medium-grade companies. But since then, medium-grade offerings outpaced high-grade offerings on average by 24% per year. By Q3, medium-grade issuance soared 47% year-over-year “despite higher yields and wider spreads,” and even as junk-bond issuance collapsed.

There are now a total of $3.36 trillion in medium-grade bonds outstanding. During the 10-year period ended in 2005, medium-grade bonds averaged 31% of total bonds outstanding. Now their share soared to 52%. The share of high-grade bonds, at $1.79 trillion, has plunged to 28% in Q3. And the share of junk bonds outstanding, the most vulnerable of the bunch, has soared to over 20%.

Many of these companies were downgraded since they issued these bonds a few years ago. And when these bonds mature, they have to be refinanced with lower-rated, and thus more expensive, debt – if they can refinance them at all.

This deterioration in credit indicates that companies are losing “financial flexibility,” as Moody’s puts it. Lower-rated borrowers are experiencing higher credit costs. For them, access to credit becomes difficult, or even impossible. That’s when they run out of money and end up in default.

Moody’s concludes:

To compensate, corporate outlays on staff and capital goods may be curbed more rapidly in response to a weaker business outlook.

This sort of cost cutting via layoffs and slashing of capital expenditures has been wreaking havoc in the energy sector for a year. But it’s spreading, as the recent rounds of layoff announcements and cost reduction programs have shown. This sort of reaction to tightening credit is how it started out at the end of last three credit booms – the ones that ended in recessions and a financial crisis.

Risks have been building up in the banking sector. “Reminds me of what happened in mortgage-backed securities in the run up to the crisis,” explained the Comptroller of the Currency. Read… “Bank Failures and Systemic Breakdowns”: Regulator Warns on Autos, Subprime, Commercial Real-Estate…

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