Corporate debt markets: The Achilles heel
US bond markets will be the canary in the coal mine in this cycle; if they falter, no one will be spared
As mentioned previously, this business cycle in the US is very long in the tooth. We are now in the second-longest economic expansion ever, and by March next year it will become the longest. Given the duration of the current expansion, many naturally worry about the next recession. When will it arrive? How severe? Which markets will get dislocated?
There is a strong feeling among many professional investors that the weak link this time will be the corporate bond market, specifically the high yield bond market. A recession will weaken corporate credit quality, and lead to losses and defaults — both of which are at cycle lows. Over the coming five years more than $4 trillion worth of corporate bonds will need to be refinanced. Is there demand for this much paper, if yields have normalised? At what interest rate can these bonds be refinanced? Can the balance sheets of many of the junk bond issuers support much higher debt servicing costs? These issues should give all investors cause to pause.
There have been two significant changes in this market over the last decade since the financial crisis.
First of all, the market is far larger than in 2008 in absolute terms. In 2008, the US had about $2.8 trillion worth of corporate bonds outstanding. This number today is north of $5.3 trillion. A decade of extremely low if not zero interest rates, a relentless search for yield on the part of investors, and a willingness to support covenant lite bonds has democratised access to the bond markets for all types of issuers. Corporate bonds, as a percentage of GDP, are over 40 per cent — an all time high.
What has changed is that due to the Dodd-Frank legislation in the US and the Volcker rule, investment banks have far less ability or interest in being market makers and maintaining an inventory of these bonds. Work done by various experts in the field indicate that in 2008, when the quantum of corporate bonds outstanding was $2.8 trillion, the banks had nearly $260 billion worth of inventory (almost 10 per cent). This inventory allowed them to make markets and provide a bid for large size. Fast forward to today, and against a stock of $5.3 trillion, the inventory with the banks is only about $40 billion (less than one per cent). This is a significant change that has not troubled the markets till date as we have seen benign market conditions over the last 10 years. The bond bull market has continued. To compensate for the absence of the banks, we have also seen hedge funds, private equity and other non-banks step up and become active players in these markets, providing liquidity and putting money to work.
The worry about these new players, mentioned above, is that their commitment to make a market has not been tested. In tough, choppy market conditions, will they still provide a bid? They are not compelled to, and faced with possible losses they may choose to withdraw from these markets at any time. This is not a core activity for these players.
The second big change is the extent to which retail investors have entered the corporate bond markets and are active participants. Back in 2008, the corporate bond market was still largely confined to institutional participants. However, in the past 10 years as we have seen this search for yield play out, retail investors have entered the corporate debt space through investments into specialised exchange-traded funds(ETFs) and also bond mutual funds. A decade ago, the quantum of money in corporate bond ETFs was only $15-20 billion; this number has now skyrocketed to almost $300 billion. By their very nature, an ETF is meant to provide daily liquidity. Retail investors are implicitly assuming that these ETFs will be liquid, with daily liquidity. These investors, by their very nature will invariably demand immediate liquidity at the bottom or when market conditions get stressed.
Therefore, this is a very different corporate bond market than 10 years ago. The market has more than doubled in size, with much greater exposure to junk issuances, dedicated market making capacity has declined by more than 80 per cent among the investment banks and for the first time we have significant retail exposure to the asset class. Retail investors — who will demand immediate liquidity at the first sign of trouble or losses. Retail investors — who have not seen a cycle in this asset class. This is a potentially toxic cocktail. If we get one large default, or just simple risk aversion, who will buy these bonds? At what price will the market clear? What will be the unintended consequences of large retail losses in bond ETFs?
The underpinnings of the US corporate bond market look shaky. This can continue for some time, and nothing may unravel in the short term. However things can fall apart very quickly and quite unexpectedly. A surge in inflation, a big corporate bankruptcy, failed M&A deal, spike in oil prices, anything can easily disrupt this fragile equilibrium.
The subprime crisis created such damage because markets locked up. Unable to sell their subprime and structured asset holdings investors were forced to sell any asset for which there was a bid. Given the lack of liquidity, prices were driven down to absurd levels as leveraged funds had no holding power. They had to take any bid on offer at whatever price. The huge losses realised drove further liquidation and deleveraging across other asset classes as well and the whole thing just spiralled out of control.
This dire scenario will hopefully not come to pass in the corporate bond markets. Yet these markets are large enough to stress the entire system. The potential lack of liquidity is frightening, as is the naivety of ETF investors who expect daily liquidity irrespective of the underlying liquidity of the asset they are exposed to. We have yet to see this liquidity mismatch tested. It is not clear how these markets will clear given the potential demand-supply imbalance. No market making capacity but huge potential demand for liquidity among retail.
Watch corporate bond markets in the US, they will be the canary in the coal mine in this cycle. If US markets get in trouble, given the global linkages in the debt markets, no one will be spared.