Wednesday 26 August 2020 4:00 am

The corporate bond market is set for a record year — but also a dangerous and dysfunctional one

Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge

2020 is going to be a record year for the corporate bonds market. New issue investment grade volume in the first half of the year exceeded $2.5 trillion. Records are also being broken in high-yield junk debt, despite a rising corporate default rate. 

Last week, the US primary market broke through $1.3 trillion of new debt, beating issuance for the whole of 2017, the previous record year. The busiest three months of the year are still to come — it’s a great time to be a debt capital markets banker.

Companies are borrowing more from markets than ever before for a number of reasons. One, there is the ongoing uncertainty over Covid — firms are raising debt to cover lost income and fixed costs. Two, banks aren’t lending, forcing companies to use debt markets. And three, central banks are keeping interest rates artificially low, and have made bonds attractive through their new “QE Infinity” bond-buying programmes, which guarantees liquidity.

Read more: Buybacks are vital for our economic health

The QE Infinity programmes have been enormously successful. They avoided a corporate bond market meltdown in March when prices were spinning 30 per cent in super-volatile zero-volume markets. It sounds like a massive bailout, but the Fed has barely had to buy any debt — the mere promise to do so has been enough to tighten bond spreads to record tight levels. The ECB’s corporate QE programme has been equally stimulative in Euro bonds. 

The attraction for investors is that QE removes much of the perceived liquidity risk: can they sell the bonds? As long as central banks say yes, then it’s a safe market. (Or so the market thinks — if confidence cracks, then it will be a very different story.)

Without QE and central banks promising to act as buyers of last resort — there would be no corporate debt provision. With banks nursing hefty Covid non-performing loans, and not lending, that would have meant more airlines, aerospace firms, and cruise lines going bust. It would have seen a massive collapse in values as companies scrambled to monetise assets by selling them. Interest rates would rise. Zombie companies — those firms that don’t make enough cash to cover their debt and only survive by borrowing more — would immediately go to the wall; 18 per cent of US companies now fall into the zombie multiverse.

Read more: No longer superheroes? Twilight of the bonds

There are, of course, consequences. All that government/central bank liquidity comes at a cost. The fixed income market might be having a record year, but it’s become completely dysfunctional. The effect of central bank liquidity is to stifle real liquidity. There is effectively no secondary market for bond. All the big funds find they can only keep buying more and more primary debt — driving demand, and causing spreads to tighten further.

Bonds look like an increasingly dangerous trade. Liquidity is not the only risk in fixed income markets. Duration, a measure of a bond’s risk versus its repayment term, has increased while returns are now so low as to be effectively meaningless. 

The result is that you own more risk for longer, and get paid less for doing so. The average yield of US investment grade debt dropped to 1.82 per cent in August. Credit risk is rising as the number of defaults rise and more companies plummet from investment grade into Junk.

Read more: Corporate bonds vs shares: eight questions answered

Ultra-low interest rates plus unlimited liquidity have fuelled this year’s bond binge. Corporates are loving it — Apple recently issued a $8bn “general corporate purposes” bond, which we all know will go to funding stock buybacks. I hope Tim Cook remembers to thank the Fed when he gets his bonus this year. Apple is getting that money for practically nothing —  the 40-year tranche paid just 2.5 per cent. And I will refrain from idle speculation on whether we will still be buying Apple’s Bright Shiny Things in 2060. 

Over the past 10 years, US corporates have spent around $9.2 trillion buying back their stock — money that wasn’t spent on building new factories, infrastructure, products or creating jobs… but boosting the bonuses of executives. These stock buybacks have largely been funded from the $11 trillion raised in the bond market over the same period.

Back in April, Boeing was able to tap the US investment grade market for $25bn. It allowed the company to avoid the embarrassment of going cap in hand to the US government for a bailout. In a market that is supposedly fixated on ethical ESG (Environmental, Social and Governance) investing, I find that extraordinary.

Over the past 10 years, Boeing has been the textbook example of everything that’s rotten with Corporate America. While it spent $42bn buying back its own stock to inflate its market capitalisation, if failed to develop new models, and instead overdeveloped the already venerable 50-year-old Boeing 737 to make it an unflyable death-trap with compromised safety; 346 passengers and crew were killed in two crashes involving the Boeing 737 Max. It’s now making staff redundant. 

Boeing will survive — but only because it is critical to the US economy (it generates one per cent of GDP in good years) and it’s a massive defence contractor.

It might be a record year for bond markets, but it’s entirely on the back of central bank distortion, and long-term that is dangerous. Rising levels of debt have the same effect as pouring wet cement on the global economy: it will set like concrete, holding back jobs, growth, and the evolution of business.

Main image credit: Getty

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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