Financial Mirror (Cyprus)

Will excessive stimulus lead to excessive leverage?

- By John Lonski John Lonski is Chief Capital Markets Economist at Moody’s Capital Markets Research

High yield bond issuance and newly rated loans from high-yield issuers have soared thus far in 2021. Layers of fiscal stimulus on top of monetary stimulus have boosted risk tolerance. The most stimulus since WWII might yet drive private-sector leverage up to heights that significan­tly increase long-term debt repayment risk.

Could it be that today’s endless stimulus does more to increase default risk than to increase consumer price inflation risk? Neverthele­ss, elevated default risk may not become manifest until corporate earnings are expected to contract materially and that may not occur until 2023 at the earliest.

There is widespread agreement that 2021’s prospectiv­e advance by real GDP will be the liveliest since 1984’s 7.2%. As derived from Federal Reserve data, the yearly increase of fourth-quarter nonfinanci­al-corporate debt outstandin­g accelerate­d from 1982’s 8.8% to 1983’s 10.4% before peaking at 1984’s 16.9%.

Perhaps worth noting is how 1984 was at the start of the high-yield bond phenomenon. Prior to Drexel’s Michael Milken, the high-yield bond market mostly consisted of formerly investment-grade issuers. It was not until the early 1980s that newly issued bonds started off with speculativ­egrade ratings.

Note that 1984’s rapid expansion of corporate debt occurred despite a rise by corporate borrowing costs. For example, after dropping from 1982’s recession-inflated 15.77% to 1983’s 12.90%, the calendar-year average of Moody’s Analytics long-term Baa industrial-company bond yield jumped to 13.84% in 1984. By contrast, the long-term Baa industrial-company bond yield has declined from 2020’s 3.81% average to a 2021-to-date average of 3.53%, where the latter includes a recent 3.67%.

In addition, unlike the rise by the annual average of the effective federal funds rate from 1983’s 9.09% to 1984’s 10.23%, 2021’s ultra-low 0.125% midpoint for fed funds is unchanged from its reading of April-December 2020.

Both low yields from other investment-grade credit market instrument­s and above-average confidence in the very positive outlook for corporate earnings have helped to narrow the Bloomberg/Barclays high-yield bond spread to April 7’s 290 basis points, which is less than each of its previous monthly readings going back to June 2007’s 256 bp.

As it turned out, the high-yield bond market’s supreme optimism of June 2007 was misplaced and by August 2007 a financial crisis had surfaced that was soon followed by the Great Recession. After June 2007, the high-yield bond spread began a protracted climb that included a bone-jarring ascent to December 2008’s 1,874 bp zenith for the high-yield spread’s month-long average.

For corporate credit, in general, the continued growth of corporate earnings practicall­y rules out anything remotely similar to what transpired in 2008-2009. Neverthele­ss, it would not be surprising if 2021’s likely combinatio­n of very low Treasury bond yields, rapid economic growth, and a breakneck expansion of corporate earnings prompts a jump in corporate debt outstandin­g.

Taken together, unsustaina­bly thin corporate bond yield spreads and expectatio­ns of significan­tly higher Treasury bond yields constitute a powerful incentive to bring corporate borrowing forward. In addition to refinancin­g outstandin­g obligation­s at lower interest rates and longer maturities, new corporate bond issues and leveraged loans may fund current and future acquisitio­ns, equity buybacks, dividends, and capital spending.

Market-Based Metrics of Default Risk Are the Lowest since 2007

The market’s assessment of high-yield default risk now resides at its lowest level since the early summer of 2007. As mentioned earlier, the Bloomberg/Barclays high-yield bond spread trails each of its prior month-long averages going back to June 2007. In addition, the 1.84% April-to-date average of Moody’s Analytics expected default frequency metric for U.S./Canadian high-yield issuers is less than each of its prior month-long averages going back to the 1.59% of June 2007, or when the high-yield bond spread averaged 256 bp.

An abundance of systemic financial liquidity can be inferred from February’s 27% year-over-year surge by the M2 measure of highly liquid financial assets, which is the fastest such increase since 1959 at least. Prior to 2020, M2’s biggest yearly advance was February 1976’s 13.8%. For each month beginning with May 2020, M2’s yearly growth rate has exceeded 20%. Thus, in terms of both growth rates and relative to GDP, M2 now far exceeds anything observed during the inflationa­ry 1970s. Still, most do not expect history to repeat itself If only because of today’s more intense global competitio­n and America’s much older workforce and population.

High-yield borrowing activity—the sum of high-yield bond offerings plus newly rated loans from high-yield issuers—set a new record-high $445 bln in 2021’s first quarter. US$-denominate­d high-yield bond issuance soared 64% annually to a record-high $212 bln, while newly rated loans from high-yield issuers advanced 82% annually to $233 bln. The latter fell short of second-quarter 2018’s $245 bln record-high for newly rated high-yield loans.

Finally, the build-up of liquidity, or working capital, was cited with an atypically high frequency among first quarter 2021’s speculativ­e-grade borrowings. The latter may reflect an attempt by high-yield bond issuers to avoid a future jump in fixed-rate borrowing costs that would accompany a greater-than-2% 10-year Treasury yield. High-yield borrowers also boosted cash balances to fund future acquisitio­ns. Finally, corporate borrowers may decide to hold aboveavera­ge amounts of cash as insurance against a possible disruptive assurance of COVID-19.

The supply of newly rated loans from speculativ­e-grade borrowers was unevenly distribute­d across rating categories. First-quarter 2021 showed a 27.6% yearly plunge by new loans rated Baa to $6.8 bln and an 88.9% yearly surge by new loans graded less than Baa to $224 bln. The latter included a 214.5% annual advance by new loans rated single-B to $147 bln. In addition, 2021’s first quarter included a 0.4% yearly dip by Ba-grade loan borrowing (to $68.7 bln) and a 184.7% yearly jump by new Caa-rated loans (to merely $8.6 bln).

As far as the moving 12-month sum of high-yield borrowing activity goes, the COVID-19 recession was the mildest on record. The moving 12-month sum of high-yield bond issuance and new loan borrowing fell by 10.7% from its February 2020 peak of $1,029 bln to a July 2020 bottom of $919 bln.

The NFIB small business survey for February found that the most frequently cited biggest problem facing small businesses was the labour quality followed by taxes and regulation­s. In February, the net percent of businesses claiming that labour quality was their biggest problem was 24 percentage points compared with only a 6-point average during the first five years of the 2010-2019 business cycle upturn.

Also, in February, a record 40% of surveyed small businesses claimed they had “hard to fill” job openings. By contrast, the share of surveyed small businesses reporting “hard to fill” job openings averaged a much lower 15.4% during the first five years of the previous business cycle upturn.

The number of unfilled job openings in the U.S. economy jumped up to 7.367 mln in February 2021, which was the strongest reading for this barometer of labour demand since the 7.478 mln of January 2019. Also, February’s job openings approximat­ed 74% of the accompanyi­ng number of officially unemployed individual­s. During the five years following the June 2009 end to the Great Recession, job openings not only averaged a much lower 28.4% of the number of unemployed persons, but the ratio also peaked at June 2014’s relatively low 53.0% (which was exactly five years after the end of the Great Recession).

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