Monday, March 11, 2019

The Next Financial Asset Crisis

A recent publication from the OECD looks at a looming problem for the global economy, a problem that has redeveloped in spite of the lessons taught by the Great Recession.  I have posted on this subject before, however, the recent analysis by the OECD suggests that the economy could be on the cusp of another financial crisis.

Let's open with this table from Investopedia which shows the bond rating systems for both Moody's and S&P/Fitch:

If a company's credit rating falls below a rating of BBB or Baa, the grade of its debt changes from investment quality to junk status.  Junk bonds are the debt of companies that are experiencing financial difficulties which increases the risk to investors as well as the yield that they must offer to entice bondholders to purchase their debt.

In the OECD's Corporate Markets in a Time of Unconventional Monetary Policy, the authors provide a detailed look at the corporate bond world, using a dataset that is comprised of almost 85,000 unique corporate bond issues by non-financial corporations from 114 countries between 2000 and 2018.  They note that since the financial crisis of 2008, non-financial companies dramatically increased their borrowing through the use of corporate bonds; over the decade between 2008 and 2018, global corporate bond issuance averaged $1.7 trillion per year compared to $864 billion in the years up to the financial crisis, a near doubling of the rate of corporate debt accrual.  They also note that the global outstanding corporate debt reached $12.95 trillion, twice as much corporate debt as existed in 2008 when the level of corporate debt reached $6.53 trillion.  Companies from advanced economies hold 79 percent of the total global outstanding amount in 2018, growing from $5.97 trillion in 2008 to $10.17 trillion in 2018.  Companies from emerging economies hold 21 percent of the total global outstanding amount in 2018, growing to $2.78 trillion, an increase of 395 percent over a decade.

Here is a graphic showing the total amount of corporate debt issued on an annual basis between 2000 and 2018:

Here is a graphic showing the total outstanding amount of corporate bonds issued by non-financial companies in 1998, 2008 and 2018:

If we focus on advanced economies, annual non-financial corporate bond issuance rose from $898 billion in 2007 to a recored level of $1.5 trillion in 2017, falling back to $1.2 trillion in 2018.  Looking at developing economies, the situation is even more exaggerated; before 2008, corporate bond issues in emerging markets averaged $70 billion annually, rising rapidly to a peak of $711 billion in 2016.  Even though corporate bond issuance has fallen in emerging markets in 2017 and 2018, it is still 750 percent higher than it was before 2008.  This growth in emerging market corporate debt can largely be attributed to the growth in China's debt as shown here:

In both advanced and developing economies, the number of unique non-financial companies that raised debt using bonds has increased since 2008 as shown on this graphic:

The number of companies in advanced economies issuing new corporate bonds rose from 1,133 in 2007 to 2,327 in 2017.  In the case of developing economies, the number of companies issuing new corporate bonds rose from 347 in 2007 to 1,917 in 2016.  In both cases, the number of new companies issuing corporate debt has fallen in 2018.

Here is a graphic showing corporate bond issuance for both the United States and Europe between 2000 and 2018:

In 2018, corporate bond issuance by American companies made up 35 percent of the global bond issuance compared to 20 percent by European companies.  In the case of American companies, the mean and median size of the bond issuance has risen substantially since the financial crisis:

Years - 2000 to 2007

Mean - $479 million
Median - $273 million

Years - 2008 to 2018

Mean - $837 million
Median -$465 million

One of the concerns expressed by the authors is the quality of the debt being issued.  Here is a graphic showing a breakdown in the credit quality of the bonds with IG being investment grade and Non-IG being non-investment (or junk) grade since 2000:

Here is a graphic showing the share of non-investment (or junk) grade bonds in global bond issuance on an annual basis and the average default rate of rated companies:

Note that the share of non-investment grade bonds plummeted to 7 percent of the total in 2008 and rose very sharply to 34 percent in 2010 and remained above or very slightly below 20 percent from 2011 to 2018.  This is the longest period of time that the share of non-investment grade bonds has remained this elevated before a downturn sets in and default rates rise as they did in 2008 and 2009.

Here is a graphic showing the composition of investment grade bonds since 2000:

As you can see, the percentage of BBB-rated bonds (the cutoff point between investment and junk grade bonds) grew at the expense of higher rated bonds, reaching 53.8 percent in 2018, the highest share of BBB bonds issued going back to 1980.  

Here is a graphic showing the composition of non-investment grade bonds since 2000:

In this case, there is a shift toward higher rated BB bonds whose share rose from 35.2 percent in the period before 2008 to 53.9 percent in 2018.  

Let's close with an examination of the global corporate bond rating index going back to 1980.  The index assigns a score of 1 to a bond if it has the lowest credit rating and 21 if it has the highest rating (there are 21 bond rating categories in total).  Here is a graphic showing how the global bond rating index has fallen over the past 4 decades:

This clearly shows the drop in quality of corporate bond issues over the past 40 years.  Unfortunately, this drop in quality has not been reflected in yield spreads as would be typical, thanks in large part to the Federal Reserve's long term experiment with ultra-low interest rates:

In closing, the author's make the following observations:

"The “amount” of corporate bond investments that may be expected to default in the case of an economic downturn may be considerably larger than that experienced in the financial crisis. This divergence may arise not just because of a prolonged period of low issuer quality… but also because of the increase in the total amount of outstanding corporate bonds from USD 6.53 trillion in 2008 to USD 12.95 trillion in 2018. Due to the lower levels of covenant protection, non-investment grade issuers may indeed escape default for a longer time as it is now less likely that they breach a covenant. Nevertheless, bond investors’ portfolios may be hurt far before the occurrence of a default event, as the expectation of a company’s default and achievable recovery rates will quickly be factored in the bond price."

The authors also note that a financial shock similar to the 2008 crisis could result in $500 billion worth of BBB-rated corporate bonds being downgraded to non-investment grade within a year, forcing sales by non-investment grade investors.  This figure could become even worse if a major issuer in the BBB category saw its credit rating drop, similar to what happened in 2005 to both General Motors and Ford Motor Company.

Corporate bond buyers - caveat emptor.  You have been warned.

1 comment:

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