If GE debt gets junked, markets have reason to shudder
With luck, firm will end up merely a case study in financial mismanagement
Holders of General Electric bonds are preparing for one of the world’s biggest borrowers to be downgraded to junk. To get a sense of what that might do to the markets, take a look back to the turmoil caused by the 2005 downgrades of General Motors and Ford—but worry that this time it might be worse because so many companies have been on a debt binge.
Back in 2005 it was easier for the overall market to shrug off the troubles in credit, because corporate debt—excluding the banks—was under control, with the boom in borrowing linked instead to mortgages. This time round companies have been the big borrowers, and the riskiest parts of the debt markets are stoking concern among policy makers.
GE’s financial troubles are self-inflicted, not a sign of broader problems in the economy. Yet, it is the world’s sixthmost indebted nonfinancial company, behind Volkswagen, Toyota, AT&T, SoftBank, Ford and Daimler. And it has more traded debt outstanding than any of them, totaling $122 billion (U.S.), according to Refinitiv. It is big enough to shake the entire market.
The same was true in 2005. GM and Ford were two of the biggest borrowers, struggling to cope with a legacy of high costs and overcapacity as competitors grabbed market share. As their downgrades to junk loomed investors unable to hold junk-rated debt dumped their bonds, while junk investors sold too, expecting their market to be swamped by the arrival of the giant car makers.
From its low in March 2005 to the post-downgrade peak U.S. junk bond yields jumped from 2.7 to 4.6 percentage points above Treasury yields, according to the ICE BAML index.
Junk yields have been rising since the start of October, up from 3.16 to 4.1 percentage points over Treasurys by the end of last week, hit by sliding stocks and the pain the falling oil price causes to indebted energy companies.
There are three crucial differences between today and 2005, which could determine whether there’s a repeat of the shortterm turmoil seen then, and whether more serious trouble looms.
The simplest difference is reassuring: GE hasn’t been downgraded to junk, and remains three rating notches above. The markets are treating GE bonds as though they had already lost investment-grade status; for example, the $1.3 billion January 2023 bond yield has leapt this year from 2.8% to 6.2%. But the credit-rating firms say that if GE’s restructuring goes as planned, there’s no need for further downgrades. If GE can get its finances under control, the panic will abate all by itself.
The second difference is about hedge funds, which were behind the 2005 havoc. A good part of the turmoil caused by the GM and Ford downgrades was due to the rapid unwind of highly leveraged wrong-way bets by hedge funds that their bonds and stocks would move together.
Hedge funds have suffered recently, but the pain appears to be focused on equity traders, perhaps because it is now harder to trade bonds, making big positions less attractive to fastmoving funds. That’s good news for the wider market—although hedge funds are opaque and it is too early to be sure that no big losses are lurking.
The third difference is broader, and more worrisome. Back in 2005, nonfinancial corporate debt was relatively small; at the end of the year the amount of bonds and other debt securities outstanding was the lowest relative to GDP since 1993. Sure, huge debt problems were building up, but in the U.S. it was mainly in banks and the financial sector.
This time the opposite is the case. U.S. banks have cut their leverage and built their capital and liquidity buffers since 2008, while nonfinancial companies have been on a borrowing spree fueled by cheap money.
With more leverage and fewer protections, the debt markets are more vulnerable to a shock today than they were, so a GE downgrade could end up more serious than the 2005 fright. Indeed, many were already worrying that excesses in leveraged loans—a type of highly-geared floating rate debt typically used in private equity buyouts, not issued by GE—could significantly worsen any economic downturn.
“It isn’t the kind of systemic risk that we saw in 2008 because the banks are that much safer and there’s probably less of a connection between [leveraged loans] and banks,” said Tobias Adrian, director of the monetary and capital markets department of the International Monetary Fund. “But still there are amplification effects.”
Hopefully GE will end up merely as a case study in financial mismanagement, rather than the trigger for messy markets. I’d expect only a short period of turmoil, rather than serious trouble, if GE is downgraded—but I do fear that the overall debt load will hurt a lot in the next economic downturn.