US corporate debt: in too deep
When the coronavirus pandemic struck the US in early March and unleashed turmoil on global markets, the Federal Reserve quickly stepped in to support the economy.
Its historic decision to buy corporate debt, including investment-grade bonds and exchange traded funds that own riskier junk credit, gave struggling companies a lifeline. But with businesses borrowing a total of $2.5tn from the bond market in 2020, the question now is whether the Fed’s help has turned into life support.
The debt binge has seen leverage — aka the ratio that measures debt compared with earnings — skyrocket to its highest level for investment grade-rated companies, according to data from Bank of America.
The problem is that some of these companies may not be able to pay back what they owe. So-called zombie companies — meaning their interest payments have topped profits for three years running — are nearing a historic peak, data from Leuthold Group show.
While the red-hot debt market has helped them keep the lights on, there is concern that future profits may not fully cover the new financial burden. Nevertheless, market players are betting on a rally in debt prices next year because they expect continued support from the Fed.
The Fed backstop has naturally raised the issue of moral hazard, similar to how the central bank’s intervention in the past has. It’s a point policymakers will have to contend with in the years after the crisis: have they conditioned investors to expect the Fed to step in any time there is turmoil?
Hedge fund billionaire Daniel Loeb briefly addressed the issue in his first-quarter letter to investors, where he criticised the Fed for its willingness to buy riskier assets, arguing that investors such as private equity groups, which are notorious for piling debt on companies, would ultimately be the beneficiaries.
“The Fed has created an expectation of a bailout,” said Alex Veroude, chief investment officer at Insight Investment, adding that it, “almost doesn’t matter” what other indicators of debt or leverage show.
It’s important to remember that the Fed was widely applauded for moving quickly, arguably averting an even greater crisis. But the concern now is whether its assistance has left businesses comatose on the central bank’s life support.
Any tips for warding off the corporate undead?