It has never been easy to accurately assess credit risk. But it’s becoming even more difficult in an era of unprecedented government intervention and cheap money.
Credit risk and interest-rate risk are increasingly intertwined. Companies look better and more capable of repaying their debts simply because overall borrowing costs are so low.
In fact, cheap financing is a reason given by the credit-rating firms such as Moody’s Investors Service when they justify the potential creditworthiness of borrowers. This has contributed mightily to the record pace of credit-rating upgrades, with nearly twice as many upgrades of junk-rated companies compared with downgrades by S&P Global Ratings this year. That’s a reversal from last year, when more companies were lowered than raised up the credit scale.
Consider the $500 million offering of junk bonds from MicroStrategy Inc., with proceeds going toward buying Bitcoin. Putting aside the wisdom of buying these bonds or borrowing money to buy digital currencies, it was telling to see how Moody’s justified its Ba3 rating. In talking about MicroStrategy, the credit-rating company said that while “leverage is extraordinarily high, the company has a very low cost of borrowing,” which “enables strong interest coverage as well as free cash flow generation.”
Leverage has ticked higher relative to where it was before the pandemic across the board, but debt is just so cheap, who truly cares? This circular logic, of good times begetting good times, is being applied throughout the $10 trillion U.S. credit market. Increasingly, firms are embedding interest-rate risk into the rating structure.
“While this company may be triple B right now, in a higher interest-rate environment they may not be,” Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments, said in an interview. “This is tricky, especially if a company has a lot of debt to roll over.”
So far it’s nothing but sunny skies on the credit horizon. Fitch Ratings recently cut its high-yield default expectation for the end of the year to 1%, which would be the lowest since 2013 and could even challenge the 0.5% mark set in 2007.
Junk-rated companies are paying the lowest rates ever to borrow for the longest period on average since 2014. Companies are borrowing money at a record pace in response to the escalating demand. Aside from refinancing more costly debt, borrowers are using money they raise to pay dividends to their private-equity owners, buy other companies, repurchase stock, you name it.
This only works up to a point, of course. It counts on borrowing costs continuing to stay low or even declining further. And it hinges on companies having relatively sound business models and an expanding economy.
These are dangerous long-term assumptions. Earnings growth is tremendous for now but destined to fade along with the pandemic. Companies are taking bigger risks given the market’s preference for future returns over safety. Meanwhile, the Federal Reserve says inflation is transitory, but a growing number of economists and central bankers disagree.
As Deutsche Bank analysts led by Peter Hooper wrote in a recent note, “Never before have we seen such coordinated expansionary fiscal and monetary policy … . This is why this time is different for inflation.”
If they’re wrong, however, and bond markets are telling a disinflationary story ahead, that may be even more worrisome for corporate credit, which relies on fast enough growth for corporations to grow into their capital structures.
Investors have shrugged off these concerns. But the more sanguine investors become about risk, the more prone markets are to potential accidents, such as a business collapsing or, say, in MicroStrategy’s case, Bitcoin plunging in price. The leverage building in the corporate sector most likely won’t unwind dangerously in the near future because of the continuing monetary accommodation, but it makes it more difficult for the Fed to gracefully extricate itself from its policies. And it makes a potential slowdown or contraction that much more painful in the future.
Yes, companies are getting upgraded rapidly this year, but the logic underpinning the rise relies on ultraeasy financing that can’t go on forever. At some point these companies will have to be judged without having the luxury of plugging financial gaps with cheap debt, and those credit scores will be so much window dressing.
Lisa Abramowicz is a co-host of ‘Bloomberg Surveillance’ on Bloomberg TV.
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