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Fed backstop masks rising risks in America’s corporate debt market

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Investors and analysts surveying the damage wrought by the pandemic have warned that it has exacerbated some of the most worrying trends in corporate debt markets and left balance sheets in a far riskier state.

US companies have borrowed a record $2.5tn in the bond market in 2020. The borrowing binge has driven leverage — a ratio that measures debt compared with earnings — to an all-time peak for higher-rated, investment grade companies, having already surpassed historic records at the end of 2019, according to data from Bank of America.

At the same time, companies’ ability to pay for the increase in debt has declined, with the number of so-called zombie companies — whose interest payments have been higher than profits for three years running — rising close to the historic peak, according to data from Leuthold Group.

Rating agencies have responded to the increase in risk by downgrading credit ratings. A record number of companies were this year rated triple C minus, one of the lowest rungs on the rating ladder — and close to double the number there were last year, according to S&P Global Ratings. 

Line chart of % of US small-cap groups with interest greater than profits for at least three years showing Attack of the zombie corporation

Yet major market players are still preparing for a rally in corporate debt prices next year, with rising risks outweighed by expectations of continued support from the Federal Reserve following the central bank’s historic decision to begin buying corporate debt in March.

“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. 

“If you think about it is insane,” he said. “It’s exactly what critics would say capitalism has created. But it’s the reality.”

In March, as asset prices tumbled and markets seized up, the Fed announced the unprecedented decision to begin buying investment-grade corporate bonds, as well as exchange traded funds that tracked either the investment-grade or the lower-rated, high yield market. 

Without even purchasing a single bond, prices began to recover, bolstered by the Fed’s support. Investor confidence in corporate America returned and the floodgates opened to fresh corporate debt raising. 

What has followed is the largest corporate borrowing spree on record, allowing companies to plug the hole in their earnings left by the shutdown of the global economy and skirt bankruptcy. The move was widely applauded for averting a more severe crisis. Jonny Fine, US head of debt syndicate at Goldman Sachs, said he viewed it, “as the most important piece of central bank policymaking I have seen in my career.”

Line chart of Yield on ICE Bank of America corporate bond indices (%) showing US corporate borrowing costs tumble

But what began with companies rushing to market to raise cash they desperately needed to stay afloat, transitioned into a red hot debt market, with companies taking advantage of demand to opportunistically sell debt at historically low borrowing costs. 

The surge in borrowing followed a decade of low interest rates that had already encouraged companies to take on cheap debt following the 2008 financial crisis. 

In the summer, the balance of power swung back from investors hoarding cash that companies desperately needed to issuers offering up debt that investors clamoured to buy, leaving them accepting higher risk despite the offer of lower returns.

Private equity companies raised debt to funnel cash into their own bank accounts through so called “dividend recapitalisations”. New ground was broken in the years-long erosion of lender protections in debt documents. 

It means that while the Fed and other central banks have curtailed the severity of the impact from coronavirus, helping open up debt markets to keep companies alive, the concern is that it has simply left businesses comatose on central bank’s life support.

Line chart of Ratio of gross debt to Ebitda showing Bond binge drives rise in corporate leverage

“Companies even in the worst affected industries now look like they will get through the pandemic but what do they look like on the other side?” said Richard Zogheb, global head of debt capital markets Citigroup. “Can they ever get out from this huge debt burden they had to take on?”

Analysts note that companies remain conservative, with much of the cash raised remaining on their balance sheets, rather than shifting to more aggressive activities like stock buybacks. The combined cash balance of S&P 500 companies has risen to a record $3.4tn, up $1.3tn from 2019 and more than three times the level seen in 2008, according to data from S&P Capital IQ. 

Some corporate finance chiefs have also already pledged to reduce leverage going forward. 

Todd Mahoney, head of investment grade debt capital markets at UBS, added that typically a rise in borrowing to recover from an economic downturn is done when yields are high, increasing the borrowing cost to companies. The sharp recovery brought about since March means much of the debt added this year has been borrowed at record low yields. “It’s not as much of a drain on margins,” he said. 

Nonetheless, there remains an open question of whether investors would be as willing to still support companies in their current condition if it were not for the implicit backing of the Fed. 

The central bank’s corporate bond-buying programme is set to end on December 31, but the Rubicon has been crossed and many investors bet the Fed will find a way to step in again if the market is hit like it was in March.



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High-priced tech stocks sink further into bear market territory

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Some of the hottest technology stocks and funds of recent months have fallen into bear market territory and investors are betting on more turmoil to come, as rising bond yields undermine the case for holding high-priced shares.

A Friday afternoon stock market rally notably failed to include shares in Tesla and exchange traded funds run by Cathie Wood, the fund manager who has become one of the electric carmaker’s most vocal backers.

Shares in Tesla fell 3.6 per cent on Friday to close below $600 for the first time in more than three months, although it had been down as much as 13 per cent at one point. The stock is down 32 per cent from its January peak, erasing $263bn in market value.

Wood’s $21.5bn flagship Ark Innovation ETF — 10 per cent of which is invested in Tesla shares — also closed lower on Friday. It is now down 25 per cent and in a bear market, defined as a decline of more than one-fifth from peak.

Clean energy funds run by Invesco, which were last year’s best-performing funds, are also in bear market territory, along with some of the highest-flying stocks in the technology and biotech sectors.

“Bubble stocks and many aggressively priced US biotechnology stocks have been the hardest hit segments of the equity market,” said Peter Garnry, head of equity strategy at Saxo Bank.

The tech-heavy Nasdaq Composite index fell into correction territory — defined as a decline of more than 10 per cent from peak — earlier this week but rebounded 1.6 per cent on Friday as bond yields stabilised.

The yield on 10-year US Treasuries yield briefly rose above 1.6 per cent early in the day after a robust employment report for February buoyed confidence in a US economic recovery. Yields were less than 1 per cent at the start of the year.

Rising long-term bond yields reduce the relative value of companies’ future cash flows, hitting fast-growing companies particularly hard.

These type of companies figure prominently in thematic investing funds run by Wood at Ark Investments. The performance of Ark’s exchange traded funds has abruptly reversed after they recorded huge inflows and strong gains for much of the past 12 months.

“The speculative tech trade is in various stages of rolling over right now,” said Nicholas Colas, co-founder of DataTrek, a research group.

Bar chart of  showing Hot stocks and funds enter bear market territory

RBC derivatives strategist Amy Wu Silverman said investors were still putting on hedges in case of further declines in high-flying securities, including options that would pay off if Tesla and the Ark Innovation fund drop in value.

The number of put options on the Ark fund hit an all-time high on Thursday, according to Bloomberg data. By contrast, demand for put options on ETFs such as State Street’s SPDR S&P 500 fund — which reflects the broader stock market — have fallen as stocks have dropped.

Demand for options normally slides as a stock or ETF slumps in value, given there was “less to hedge, since you got your down move”, Silverman said. The elevated put option activity on speculative tech stocks and funds was “suggesting investors believe there is more to go”, she said.

Even after the declines, stocks in the Ark Innovation ETF remain highly valued, with a median price-to-sales ratio of 22 versus 2.5 for the broader stock market according to Morningstar, the data provider.

Two of the fund’s other big holdings, the streaming company Roku and the payments group Square, were also lower on Friday, extending recent declines.

Ark’s other leading ETFs have also retreated sharply as air has come out of Tesla and other hot stocks. Tesla is the largest holding in Ark’s $3.3bn Autonomous Tech and Robotics fund and its $7.2bn Next Generation Internet ETF.

Wood has also taken concentrated holdings in small, innovative companies. Ark holds stakes of more than 10 per cent in 26 small companies across its five actively managed ETFs, according to Morningstar.

“These large stakes raise concerns around capacity and liquidity management,” said Ben Johnson, director of passive funds research at Morningstar. “The more of a company the firm owns, the more difficult it will be to add to or reduce its position without pushing prices against fund shareholders.”

Ark did not respond to a request for comment. The Ark Innovation ETF is still sitting on a performance gain of 120 per cent for the past year. It bought more shares in Tesla when the carmaker’s shares began falling last month.



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Powell inflation remarks send Asian stocks lower

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Asian stocks were mostly lower after a rout in US Treasuries spread to the region after comments from Jay Powell that failed to stem inflation concerns in the US.

Hong Kong’s Hang Seng dropped 0.3 per cent following the remarks by the chairman of the US Federal Reserve while Japan’s Topix rose 0.1 per cent and the S&P/ASX 200 fell 0.8 per cent in Australia.

China’s CSI 300 index of Shanghai- and Shenzhen-listed stocks dropped as much as 2 per cent before pulling back to be down 0.5 per cent by the end of the morning session, after Beijing set a target of “above 6 per cent” for economic growth in 2021.

Premier Li Keqiang hailed China’s recovery from an “extraordinary” year and said the government wanted to create at least 11m urban jobs at a meeting of the National People’s Congress, the annual meeting of the country’s rubber-stamp parliament.

“A target of over 6 per cent will enable all of us to devote full energy to promoting reform, innovation and high-quality development,” Li said, adding that Beijing would “sustain healthy economic growth” as it kicked off the new five-year plan.

Analysts were less sanguine on China’s economic outlook, however, pointing to the markedly lower growth target relative to recent years.

“There is, in fact, not much surprise from the government work report except for the super-low GDP target,” said Iris Pang, chief economist for Greater China at ING, who estimated growth would be 7 per cent this year. “This makes me feel uneasy as I don’t know what exactly the government wants to tell us about the recovery path it expects.”

The mixed performance from Asia-Pacific stocks came after Powell failed to alleviate fears that the US central bank was reacting too slowly to rising inflation expectations and longer-term Treasury yields, which rise as bond prices fall.

Powell on Thursday said he expected the Fed would be “patient” in withdrawing support for the US economic recovery as unemployment remained well above targeted levels. But he added that it would take greater disorder in markets and tighter financial conditions generally to prompt further intervention by the central bank.

“As it relates to the bond market, I’d be concerned by disorderly conditions in markets or by a persistent tightening in financial conditions broadly that threatens the achievement of our goals,” Powell said.

Yields on 10-year US Treasuries jumped 0.07 percentage points to 1.55 per cent following Powell’s remarks. In Asian trading on Friday, they climbed another 0.02 percentage points to 1.57 per cent. The yield on the 10-year Australian treasury rose 0.07 percentage points to 1.83 per cent

“Based on our growth forecast, longer-term rates will likely rise for the next few quarters — but more slowly,” said Eric Winograd, a senior economist at AllianceBernstein. “And we think the Fed is prepared to push in the other direction if rates rise too far, too fast.”

The S&P 500, which closed Thursday’s session down 1.3 per cent, was tipped by futures markets to fall another 0.1 per cent when trading begins on Wall Street. The FTSE 100 was set to fall 0.8 per cent.



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Financial bubbles also lead to golden ages of productive growth

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Sir Alastair Morton had a volcanic temper. I know this because a story I wrote in the early 1990s questioning whether Eurotunnel’s shares were worth anything triggered an eruption from the company’s then boss. Calls were made, voices raised, resignations demanded. 

Thankfully, I kept my job. Eurotunnel’s equity was also soon crushed under a mountain of debt. Nevertheless, the company was refinanced and the project completed. I raised a glass to Morton’s ferocious determination on a Eurostar train to Paris a decade later.

With hindsight, Eurotunnel was a classic example of a productive bubble in miniature. Amid great euphoria about the wonders of sub-Channel travel, capital was sucked into financing a great enterprise of unknown worth.

Sadly, Eurotunnel’s earliest backers were not among its financial beneficiaries. But the infrastructure was built and, pandemics aside, it provides a wonderful service and makes a return. It was a lesson on how markets habitually guess the right direction of travel, even if they misjudge the speed and scale of value creation.

That is worth thinking about as we worry whether our overinflated markets are about to burst. Will something productive emerge from this bubble? Or will it just be a question of apportioning losses? “All productive bubbles generate a lot of waste. The question is what they leave behind,” says Bill Janeway, the veteran investor.

Fuelled by cheap money and fevered imaginations, funds have been pouring into exotic investments typical of a late-stage bull market. Many commentators have drawn comparisons between the tech bubble of 2000 and the environmental, social and governance frenzy of today. Some $347bn flowed into ESG investment funds last year and a record $490bn of ESG bonds were issued. 

Last month, Nicolai Tangen, the head of Norway’s $1.3tn sovereign wealth fund, said that investors had been right to back tech companies in the late 1990s — even if valuations went too high — just as they were right to back ESG stocks today. “What is happening in the green shift is extremely important and real,” Tangen said. “But to what extent stock prices reflect it correctly is another question.”

If the past is any guide to the future, we can hope that this proves to be a productive bubble, whatever short-term financial carnage may ensue.

In her book Technological Revolutions and Financial Capital, the economist Carlota Perez argues that financial excesses and productivity explosions are “interrelated and interdependent”. In fact, past market bubbles were often the mechanisms by which unproven technologies were funded and diffused — even if “brilliant successes and innovations” shared the stage with “great manias and outrageous swindles”.

In Perez’s reckoning, this cycle has occurred five times in the past 250 years: during the Industrial Revolution beginning in the 1770s, the steam and railway revolution in the 1820s, the electricity revolution in the 1870s, the oil, car and mass production revolution in the 1900s and the information technology revolution in the 1970s. 

Each of these revolutions was accompanied by bursts of wild financial speculation and followed by a golden age of productivity increases: the Victorian boom in Britain, the Roaring Twenties in the US, les trente glorieuses in postwar France, for example.

When I spoke with Perez, she guessed we were about halfway through our latest technological revolution, moving from a phase of narrow installation of new technologies such as artificial intelligence, electric vehicles, 3D printing and vertical farms to one of mass deployment.

Whether we will subsequently enter a golden age of productivity, however, will depend on creating new institutions to manage this technological transformation and green transition, and pursuing the right economic policies.

To achieve “smart, green, fair and global” economic growth, Perez argues the top priority should be to transform our taxation system, cutting the burden on labour and long-term investment returns, and further shifting it on to materials, transport and dirty energy.

“We need economic growth but we need to change the nature of economic growth,” she says. “We have to radically change relative cost structures to make it more expensive to do the wrong thing and cheaper to do the right thing.”

Albeit with excessive enthusiasm, financial markets have bet on a greener future and begun funding the technologies needed to bring it to life. But, just as in previous technological revolutions, politicians must now play their part in shaping a productive result.

john.thornhill@ft.com



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