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How much to worry about rising defaults

Sooner or later, we are all but guaranteed to get some trouble in corporate debt markets, for the simple reason that rates have risen by almost 5 percentage points in just a few years. Some increase in corporate distress is foreseeable, maybe even healthy. But will it stop at “some”? Is it a matter of the normal credit cycle returning, and companies with fragile financing heading for bankruptcy or restructuring? Or might we be headed for a credit crisis large enough to cause problems at financial institutions, causing market and economic contagion?

These are the questions posed by an excellent Big Read by our colleague Harriet Clarfelt. You should read the whole thing, but we’ll recap the main points.

It begins by disclaiming that things now are fine — that most current defaults are caused by industry- or company-specific issues. But there are worries about the future, as monetary policy continues to squeeze companies and the economy slows. We noted four in the piece: small companies, leveraged loans, extend-and-pretend tactics and private markets. In that order:

[On smaller firms] A recent survey by the National Federation of Independent Businesses showed that US small-caps were paying almost 10 per cent interest on short-term loans in September, up from lows of 4.1 per cent in mid-2020

[On loans] Cash interest coverage on newly issued loans had dropped to 3.16 times by the end of the third quarter, its lowest level since 2007 if compared with previous full years. Interest coverage has also declined for existing loans, data from PitchBook LCD shows, signalling that earnings are not growing quickly enough to keep pace with rising borrowing costs

[On extend-and-pretend and private markets] “If we look at the first three-quarters of this year, distressed exchanges [a type of workout for a faltering company] comprise roughly two-thirds of all corporate family defaults in the US,” says Julia Chursin, senior analyst at Moody’s. She adds that “the majority of them — 78 per cent — were done by private-equity owned companies”

Right now, relatively few companies are getting into trouble, but the trend is poor. Moody’s keeps a list of companies that are rated triple-B-negative or lower, that is, companies which are either C-rated (“of poor standing and subject to very high credit risk”) or right on the cusp of it. The Moody’s chart below shows that the size of that list, in both absolute numbers and as a percentage of the whole high-yield (“speculative grade”) universe, are only slightly above the long-term average, while the default rate is still below the levels of 2015-16, when low oil prices caused a series of defaults in the energy sector:

What that chart shows in the future will be determined by how two vectors — the path of interest rates and probability of recession — interact. When debt needs to be rolled over, the cost of new debt and corporate cash flows must co-operate to avoid problems.

To begin with the first vector, rates, the question is how long companies can wait, hoping for inflation to subside and rates to fall. Much, perhaps too much, is made of the “maturity wall”, the point in the future when a large bolus of debt will have to be refinanced. Cramming all high-yield debt together into a single sum, without adding a measurement of companies’ ability to pay, doesn’t tell you all that much. That said, aggregate maturities give some sense of how bad things might get at their worst, and when. And right now, the picture is not too bad in the US, at least for the next two years. The junk bond and leveraged loan markets total $3tn in outstanding debt between them. For less than $150bn of refinancing to cause a credit market contagion, economic conditions will have to be pretty bad. 

Still, a high-rate, recessionary world could be catastrophic for borrowers, who would be pinched by both rising interest expense and falling sales. But such a stagflationary outcome looks remote. More likely is either a low-rates recession, as the Federal Reserve cuts rates to boost activity, or a soft landing where the Fed lowers rates only a little.

A high-rates soft landing is not a common occurrence in history, but chances are it would be survivable. Economic growth gives companies options for staving off default. Capex, a significant expense that is somewhat discretionary, can be cut; so can employment levels. In a pinch, companies can also reduce debt by raising equity, so long as economic conditions are OK. Interest rates are important, but for companies with a functional business model in a growing economy, they are one expense line out of many.

On the other hand, a recession with low rates has happened many times before, and it is plainly bad for creditors, and could be worse this time. Even in a recession, rates might not be as low as the pre- and early-pandemic period in which today’s corporate balance sheets were built. (Virtually every episode of rising default rates in the high-yield bond market is explained by either recession or plunging oil prices, Marty Fridson of Lehmann Livian Fridson Advisors points out.)

So, what are the chances that we get a recession combined with only moderately lower rates, one that starts late enough or lasts long enough to coincide with a high volume of refinancing demand? That is the (slightly long-winded) question. 

It is important to note that bond markets are emphatically not signalling trouble ahead. Spreads over Treasuries of triple-B (lowest rung of investment grade) and double-B and single-B (upper parts of high yield) bonds were higher earlier this year, before long term interest rates jumped, and not far from pre-pandemic levels:

Banks, which have been notably cautious lately, seem to be relaxing a bit, too. The Fed’s latest loan officer survey recently came out, and reported that fewer banks are tightening lending standards for business loans: 

So (consistent with our case for economic optimism yesterday) while there is no doubt that plenty of individual firms will be forced into restructuring by high rates, the chances of a corporate debt crisis seems low as of now. 

But there is an important proviso. One complication in gauging credit risks is that some of the riskiest debt has migrated to private markets. That has been a factor in making public debt markets, especially for high-yield bonds, less risky. Fridson estimates that if default patterns similar to the mild recession in 2001 repeat in 2023, the high-yield bond default rate would peak at 8.5 per cent, versus 11.3 per cent in the dotcom bust, because of better company quality in the public markets. Moody’s forecasts that in a non-recession scenario, the default rate will stay below 5 per cent across public speculative-grade debt.

But even short of a recession, rising defaults may matter most in private markets, which mostly use floating-rate debt. The early signs are troubling. As Harriet’s piece notes, PE-backed distressed exchanges make up a major chunk of this year’s defaults. 

The problem for PE is that it is getting harder to shunt losses on to creditors. Researchers have found that high-yield bondholders in leveraged buyouts underperform bond benchmarks, and the underperformance gets worse the more experienced the PE backer is. Enter private credit, which has snapped up LBO debt by offering faster, nimbler loan execution than public markets in exchange for fatter spreads and tighter contracts. If a company defaults, or needs a distressed exchange, someone somewhere must take a haircut. That is a recipe for a legal knife fight between private lenders and private equity investors, a fight both sides could lose. (Armstrong & Wu)

Franchise network run by Transport for London, a local government body, hailed as a way forward

Nearly 40 years after local bus services across most of Britain were privatised, momentum is building to reverse the move in many areas.

Margaret Thatcher’s 1986 reforms were intended to increase competition and improve a service relied upon by millions of passengers a day. However, after years of declining ridership, local leaders have begun to unpick the overhaul by the Tory prime minister, arguing it has failed on every measure. 

They point to the success of London’s extensive bus network, which was left untouched by deregulation and remains under the control of Transport for London, a local government body.

As bus journeys across the capital have grown, under a franchising model common across much of Europe by which private companies run services while TfL retains overall control, ridership elsewhere has fallen by 40 per cent since privatisation and car ownership has risen, according to government data.

Local leaders argue that adopting a similar franchising model to London’s across the country is essential both to closing the economic divide with the capital and to meeting climate change targets.

Liverpool is among those to have adopted the system. “The reason we’re franchising our buses is not based on ideology, but on simple economics,” said Steve Rotheram, Labour mayor of Liverpool city region. Public control would put “passengers before profit”, he said, by allowing local leaders to keep more of the income from fares and reinvest it in the network and in boosting productivity.

“We’ve got decades of evidence that a deregulated system leaves behind the very people who need it most,” he added.

Thatcher’s 1980s reforms allowed private operators across the UK, except for London and Northern Ireland, the choice of which bus services to run and how much to charge.

Buses remain by far the biggest form of public transport — accounting for about half of all journeys. But BBC analysis has found that, in some areas, networks have shrunk by up to half, as operators have cut less profitable routes and local authorities have been forced to withdraw subsidies in response to cuts in central government funding. 

Rotheram has taken his cue from another Labour mayor in north-west England — Greater Manchester’s Andy Burnham — who in September began using the franchising model to bring buses back under public control by tapping into powers given to local authorities in 2017.

“I think in some ways it represents the coming of age of English devolution, in that a decision has been taken that rows back some of the misguided policies of the 1980s,” Burnham said at the time.

In recent weeks other Labour mayors, in West Yorkshire, Cambridgeshire and Peterborough, have announced plans to follow suit. The Labour government in Wales is also looking at similar changes.

Local politicians from other parties are also considering an overhaul of local bus services, including Andy Street, Tory mayor of West Midlands, Oxfordshire county council, run by Liberal Democrats and Greens, and Glasgow council, led by the Scottish National party.

Andrew Carter, chief executive of the Centre for Cities think-tank, said “rubbish” public transport was increasingly considered a factor in the poor economic performance of UK cities relative to those in other European countries.

Deregulation represented an “old experiment”, added Carter, one that is “universally regarded” across parties, cities and districts as “having failed”. 

Research by data analyst Tom Forth in 2019 concluded that Birmingham’s size — and therefore access to its labour market — effectively halved during rush hour because of poor bus services. His research concluded that this could explain most of Birmingham’s productivity gap with its European comparators. 

Those findings have been particularly influential in central government, which has begun to take a more active interest in bus policy, according to one local transport official.

A Centre for Cities paper on Glasgow’s public transport network that argued for a switch to franchising drew similar conclusions last month, estimating that better bus services could increase the city’s effective population by 24 per cent.

Graham Vidler, CEO of the Confederation of Passenger Transport, the trade association for the UK’s bus and coach sector, said he expected franchising to “only gain more prominence in the coming months”. 

But he warned financial support was crucial. “In the end, it will take more than a change of regulatory framework to give millions of passengers the service they deserve,” because networks “require a real, sustained investment in the things that matter most to passengers.”

Alistair Hands, regional managing director at Arriva UK Bus, which runs services in London, Wales and Liverpool, said experience in the capital had shown franchised systems could work well, “when combined with measures to promote passenger growth”, such as bus priority lanes. Echoing Vidler, he said that included the need for sustained, long-term investment.

The strain on local government finances is seen as the biggest impediment to change. Regional mayors pushing for franchising have met resistance from council leaders worried about taking on further funding obligations given the dire state of budgets.

Upfront costs alone can run into tens of millions of pounds. Greater Manchester had to budget £85.7mn just for buying and refurbishing bus depots. Burnham has already proposed a hotel tax as one revenue stream once the existing bus funding package runs out in 2025.

Many local leaders believe more central government subsidies will be needed to build out networks. State funding for bus services is low compared to rail, despite a Department for Transport analysis of major bus schemes showing they “delivered benefits worth more than four times their cost”.

Although the UK government has committed new funding to English bus networks since 2019, passengers still only receive 32 pence in subsidy per journey, according to CPT analysis, compared to £3.32 for rail passengers. Scotland has larger gaps. 

Sandy Easedale, owner of McGill’s, the largest independent bus operator in Scotland, who is opposed to the changes, warned that “hundreds of millions” of pounds in investment would be needed to create the sort of improved networks being mooted by local leaders.

“They want this wonderful service everywhere, which is fine, but somebody has got to pay for it,” he said. He promised to “fight tooth and nail in the courts” against any attempts to shift to franchising.

World’s biggest producer has scaled back its growth plans at a time when Chinese rivals pursue development

Albemarle, the world’s largest lithium company, has warned it could lose market share to Chinese producers after a $4.2bn deal to buy an Australian rival foundered and a collapse in prices prompted a pullback on expansion plans.

The US company last week revealed a review — entailing a reduction and reordering — of its capital expenditure plans in response to investor concerns over spending heavily during a market downturn.

Last month Gina Rinehart, Australia’s richest woman, wrecked Albemarle’s bid to take over Liontown Resources, a crucial acquisition for the company to grow its pool of resources after she built up a strategic stake.

Kent Masters, chief executive of Albemarle, acknowledged the group would be likely to lose market share to Chinese rivals as plummeting prices for the metal vital to batteries in electric cars have led it to pursue a more conservative approach.

“We’re being a little more cautious and investing behind the market, so there’s a risk we lose that share,” he said. “This will probably be helpful for Chinese suppliers.”

Albemarle is on course to hold a 13 per cent share of the global market this year versus 63 per cent for Chinese companies, according to Fastmarkets, while it is the biggest lithium group by market capitalisation.

The scaling back of growth plans by Albemarle highlights a strategic dilemma facing western metals groups as they struggle to invest while commodity prices fall. In contrast, Chinese companies are pushing ahead with development plans, despite the weak market.

Metals analysts say the inability of western companies to invest when cash flows drop is creating a problem for the US and Europe in the race against Beijing for critical minerals in the EV supply chain.

Despite the bumper profits over the previous two years, lithium producers have huge outlays of spending to meet forecasts of a big jump in demand. Albemarle predicts the market will increase fourfold by 2030.

Lithium prices have dropped more than 70 per cent this year to just over $22,000 a tonne, according to Benchmark Mineral Intelligence, on weak EV demand in China and the battery supply chain using up stockpiled material rather than buying fresh material.

As a result of weaker prices, net income for Albemarle tumbled 65 per cent to $320mn in the third quarter and cut its annual sales growth forecast from 40-55 per cent three months ago to 30-35 per cent.

Executives at Albemarle said they were puzzled as to why lithium prices have fallen so low, given that they believe EV demand remains strong.

Despite the likes of LG Energy Solution, Tesla and General Motors warning that high interest rates would hit EV expansion plans, Albemarle believes global sales in 2023 are still on track to hit almost 15mn units, growth of more than 40 per cent year-on-year.

“What we would have thought and believed was that they wouldn’t have gone below $25 per kilogramme. They have. I think all that says is we are in for more volatility,” said Eric Norris, president of Albemarle’s lithium business unit.

“When you have prices that low, inventories that low and the market is still growing, you’re going to see a pretty hard bounce at some point,” he added.

Rinehart also threw a spanner in the works for another Australian deal for the battery metal after building a strategic stake in Azure Minerals that Chilean lithium powerhouse SQM agreed to buy.

Despite the risk of her intervening in deals, Masters insisted Albemarle still had appetite to consider acquisitions of Australian producers and said they have yet to give serious consideration to partnering with Rinehart.

Dependence on supplies from Moscow-controlled Rosatom also threatens climate goals, official warns

US reliance on Russia’s nuclear fuel poses a critical threat to national security and climate goals, said a senior Biden administration official, who urged Congress to provide funds to rebuild its domestic supply chain and restrict imports from the country.

Kathryn Huff, assistant secretary for nuclear energy, told the Financial Times it was “gravely concerning” that about 20 per cent of fuel used by the US nuclear reactor fleet is supplied through enrichment contracts with Russian suppliers.

Russia controls almost 50 per cent of global enrichment capacity and had worked successfully to undermine the US nuclear supply chain over many years by dumping cheap enriched uranium products on world markets, she said.

“It’s really critical that we get off of our dependence, especially from Russia,” Huff said in an interview.

“Without action Russia will continue to hold on to this market . . . this is really important for national security, for climate, for our energy independence.”

The US and its allies imposed sanctions against Russia’s oil and gas industries following Vladimir Putin’s full-scale invasion of Ukraine last year, costing Moscow tens of billions of dollars in lost revenues. But Washington has refrained from preventing Russia’s nuclear giant Rosatom from selling nuclear fuel and enrichment services to US and western power plant operators, as there are few alternative supply sources.

The nuclear fuel supply chain begins with mining and milling uranium ore. But it is the chemical process of converting the ore into uranium hexafluoride gas and then enriching the uranium-235 isotope to a level of about 5 per cent that is required for standard forms of nuclear fuel — and this is dominated by Rosatom, experts say.

There are only a handful of western suppliers of enrichment for nuclear fuel, including France’s Orano and Urenco, a UK, German and Dutch consortium. Tenex, a subsidiary of Rosatom, is the only company in the world providing commercial sales of a new type of fuel called Haleu — high-assay low-enriched uranium — that is enriched to between 5-20 per cent and could power a new generation of smaller, more efficient reactors.

Huff said the Biden administration had asked Congress for an extra $2.16bn to support a strategy to incentivise US-based companies to boost enrichment and conversion capacity. The plan would make the Department of Energy a long-term buyer of last resort for companies to assure adequate fuel supply for the expanding future nuclear reactor fleet, she said.

However, the success of this public investment would depend on imposing long-term restrictions on Russian nuclear products and services, she said.

“We have seen in the past that the dumping of cheap Russian enriched uranium products has historically really damaged our fuel cycle and has brought us to where we are today,” said Huff, adding there was bipartisan support for nuclear energy in Congress.

A bill banning uranium imports from Russia passed a subcommittee in the House of Representatives in May. A similar bill is before the Senate.

Concerns about the west’s reliance on Russian nuclear products have helped push up the price of uranium and related products, as utilities seek alternative sources of supply.

“There is alignment in our industry to step away from Russia, but you need something to step to. We really need to increase capacity in that part of the supply chain,” said Maria Korsnick, chief executive of the Nuclear Energy Institute, an industry group in Washington.

The nuclear industry is growing as China and others expand their reactor fleet to meet emissions reduction targets while increasing baseload power capacity.

Huff said five to 10 contracts to build new reactors needed to be signed within the next two to three years if the US were to meet its 2050 climate goals.

“In the next two or three years we need to see those contracts in hand, or else we will not reach the commercial lift-off that is required to get to the amount of clean power we need for 2050,” she said.

The US is working closely with allies — Canada, France, Japan and the UK — to secure the supply chain and has begun funding some projects. It is supporting an expansion of capacity at Urenco’s enrichment plant in New Mexico, which is expected to be complete by 2027.

The Department of Energy has also co-funded a pilot project led by Centrus, which expects to produce its first batch of Haleu fuel within weeks.

“Legally, Russian materials are still available and being bought and sold,” said Daniel Poneman, Centrus chief executive. “But the politics around it have transformed dramatically and not all, but many of the current importers of Russian enriched uranium would like to move to other sources of supply.”