The power of saying No
In December 2012, our newsletter entitled “The power of saying Yes” played on the famous Crédit Lyonnais slogan from the 1990s. This slogan perfectly embodied the boom in companies raising credit through corporate bonds, and the shift from traditional bank loans to market-based financing.
Six years on, the story has gone into reverse as markets have become pickier about who they fund. The wind-down of quantitative easing policies across the world marks the start of a new era, one where the easy-credit tap that had generously been opened by central banks is gradually being turned off. The outlook is getting harder to read for investors. By end-November they had already withdrawn a record USD 65.3 billion from funds specialising in high yield corporate bonds and USD 25 billion1 from corporate investment grade funds. Finally, credit indices look set to end the year in negative territory2, to an extent unseen since 2008.
There are many reasons why the easy-credit era is ending. The vigour of the US economy plus a clear rise in salaries are good grounds for a rate tightening. The logical hike by the US Federal Reserve in rates for short-term bills – from zero to 2% – and 10-year notes – from 1.4% to over 3% – largely explains the woes of dollar-denominated assets.
In the eurozone, while the risk-free rate has varied only marginallyin 2018, a widening of risk premiums has pushed up financing costs for companies. A slowing economy, Brexit fears and the Italian budget stand-off coincided with the European Central Bank’s announcement that its asset purchase program would come to an end. The program has hitherto been a major prop for the market. The ECB has been buying over a billion euros of corporate debt every week, notably as an active buyer on the primary market, and now holds nearly EUR 180 billion of corporate bonds in its coffers.
As for securities, many companies have seen their bond yields spiral following disappointing results. Markets have been quick to punish any company whose results failed to match expectations.Investors are now worried about companies’ ability to repay their borrowings and demand much higher risk premiums. For instance, a rash of volatility in crude oil prices and disappointing cash flow drove the yield on the Vallourec 2023 bond to over 13%.
As the end of the cyclical upswing approaches, we typically see a rise in bankruptcies. Coface economists have confirmed this for 2019, estimating a jump in default rates to 0.8%. A modest increase, but one that chimes with the slowdown in French GDP growth to around 1.5%, a factor traditionally associated with rising bankruptcies.
It is therefore beyond doubt that the overblown credit market is a thing of the past and the clean-up is already well under way. Those who had forgotten about the volatility and short-term incoherences of markets may struggle with this return to normality. But we can see it as both necessary and positive. It restores the value of understanding the companies in which you are investing to its right and proper place.
Didier Le Menestrel
1 Source EPFR
2 Bank of America Merrill Lynch bond indices – Bloomberg