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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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A blueprint for central bank digital currencies

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Britain’s choice of world war two codebreaker Alan Turing to feature on its new plastic £50 note is ironically apt, and for several reasons. His work on cryptography speaks to the new front in monetary debates — how best to protect personal data in an age of digital payments. At the same time, the discrimination the war hero faced for his sexuality shows why privacy is important, including from the government.

In an interview with the Financial Times this week, European Central Bank executive Fabio Panetta said that a digital euro would protect consumer privacy — the public’s greatest concern over a central bank digital currency, according to a consultation by the ECB. Referring to Facebook’s attempt to launch the Libra stablecoin, Panetta warned that if central banks did not provide an alternative they would cede the ground to Big Tech. Companies could then use their dominant market position to set privacy standards.

Central bank digital currencies, however, raise questions about how to protect data from the state. If CBDCs became the dominant money then central banks could have vast data repositories of nearly every transaction in an economy. The need to clamp down on illegal money laundering would mean central banks, just like commercial banks today, would not allow individuals to hold their money anonymously — linking these transactions, however compromising, to individuals.

That might be acceptable in authoritarian regimes like China, where a digital currency project is moving ahead at pace. In democracies it is not. For this reason the Bank for International Settlements is right to call for the preservation of a two-tier financial system in its annual economic report. The so-called central bankers’ central bank advocates an account-based design with regulated private banks dealing with the public and the central bank maintaining digital currencies to make the payment system more efficient. It calls for digital identities tied to these accounts — fighting identity fraud as well as money laundering.

This arms-length structure would preserve privacy — since the state could access records only once a criminal investigation begins — and allow the private and public sector to do what they do best. The BIS argues the central bank coins could work as the plumbing of the system while banks and others could innovate and have responsibility for keeping data secure. Alternative token-based designs for a digital currency could preserve anonymity but facilitate crime.

One such token in the private sector, bitcoin, is the favoured means of payment for hackers’ ransom demands, as well as for some of those avoiding tax; this week the South Korean government seized millions of dollars’ worth of cryptocurrency from 12,000 people accused of tax evasion. Monero, a cryptocurrency that promises even more privacy than the pseudonymous bitcoin, has started to become the choice of many criminals. Cash has the same problem: at one point investigators concluded 90 per cent of £50 notes were in the hands of organised crime.

A two-tier financial system means banks could, as they do at present, have responsibility for checking identities and keeping up with “know your client” rules. While state-run identity schemes such as India’s Aadhar can be used to make sure digital currencies are going to the right place, there are valid ideological questions about government-run ID schemes. The BIS blueprint is a good start for central banks considering digital currencies, but more radical steps such as handing more personal data to the central banks need more widespread consultation and support.



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Pakistan’s Gwadar loses lustre as Saudis shift $10bn deal to Karachi

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Saudi Arabia has decided to shift a proposed $10bn oil refinery to Karachi from Gwadar, the centre stage of the Belt and Road Initiative in Pakistan, further supporting the impression that the port city is losing its importance as a mega-investment hub.

On June 2, Tabish Gauhar, the special assistant to Pakistan’s prime minister on power and petroleum, said that Saudi Arabia would not build the refinery at Gwadar but would construct it along with a petrochemical complex somewhere near Karachi. He added that in the next five years another refinery with a capacity of more than 200,000 barrels a day could be built in Pakistan.

Saudi Arabia signed a memorandum of understanding to invest $10bn in an oil refinery and petrochemical complex at Gwadar in February 2019, during a visit by Crown Prince Mohammad Bin Salman to Pakistan. At the time, Islamabad was struggling with declining foreign exchange reserves.

The decision to shift the project to Karachi highlights the infrastructural deficiencies in Gwadar.

A Pakistani official in the petroleum sector told Nikkei Asia on condition of anonymity that a mega oil refinery in Gwadar was never feasible. “Gwadar can only be a feasible location of an oil refinery if a 600km oil pipeline is built connecting it with Karachi, the centre of oil supply of the country,” the official said. There is currently an oil pipeline from Karachi to the north of Pakistan, but not to the east.

This article is from Nikkei Asia, a global publication with a uniquely Asian perspective on politics, the economy, business and international affairs. Our own correspondents and outside commentators from around the world share their views on Asia, while our Asia300 section provides in-depth coverage of 300 of the biggest and fastest-growing listed companies from 11 economies outside Japan.

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“Without a pipeline, the transport of refined oil from Gwadar [via road in oil tankers] to consumption centres in the country will be very expensive,” the official said. He added that at the current pace of development he did not see Gwadar’s infrastructure issues being resolved in the next 15 years.

The official also hinted that Pakistan’s negotiations with Russia for investment in the energy sector might have been a factor in the Saudi decision. In February 2019, a Russian delegation, headed by Gazprom deputy chair Vitaly A Markelov, agreed to invest $14bn in different energy projects including pipelines. So far these pledges have not materialised, but Moscow’s undertaking provided Pakistan with an alternative to the Saudis, which probably irritated Riyadh.

Arif Rafiq, president of Vizier Consulting, a New York-based political risk firm, told Nikkei that a Saudi-commissioned feasibility study on a refinery and petrochemicals complex in Gwadar advised against it. “Saudi interest has shifted closer to Karachi, which makes sense, given its proximity to areas of high demand and existing logistics networks,” he added.

Rafiq, who is also a non-resident scholar at the Middle East Institute in Washington, considers this decision by the Saudis as a setback for Gwadar, the crown jewel of the China-Pakistan Economic Corridor, the $50bn Pakistan component of the Belt and Road.

The Saudi decision “is a setback for Pakistan’s plans for Gwadar to emerge as an energy and industrial hub. Pakistan has struggled to find a viable economic growth strategy for Gwadar,” he said. Any progress in Gwadar in the coming decade or two will be slow and incremental, he added.

Local politicians consider the shifting of the oil refinery a huge loss for economic development in Gwadar. Aslam Bhootani, the National Assembly of Pakistan member representing Gwadar, said the move is a loss not only for Gwadar but for all of the southwestern province of Balochistan. He said he would urge the Petroleum Ministry of Pakistan to ask the Saudis to reconsider their decision.

The decision has shattered the image of Gwadar as an up-and-coming major commercial hub. In February 2020, the Gwadar Smart Port City Masterplan was unveiled, forecasting that the city’s economy would surpass $30bn by 2050 and add 1.2m jobs. Local officials started calling Gwadar the future “Singapore of Pakistan”.

Rafiq said such dreams are unrealistic. “A more prudent strategy [for Pakistan] would be to use the city as a vehicle for sustained, equitable economic growth for Balochistan, especially its Makran coastal region,” he said.

Relocating the refinery from Gwadar to already developed Karachi also implies that CPEC, or BRI, has failed to promote Gwadar as a mega-investment hub. “Foreign direct investment in Gwadar will be limited and will remain exclusively Chinese,” an Islamabad-based development analyst said, “limiting the city’s scope for development”.

The refinery decision has once again exposed the infrastructural shortcomings of Gwadar, which Pakistan and China have failed to address in the past six years. Without highways and railways connecting it with northern Pakistan, the city will never develop as its proponents hope.

A version of this article was first published by Nikkei Asia on June 13, 2021. ©2021 Nikkei Inc. All rights reserved.

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Oil hits highest price since April 2019 before moderating

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The price of crude oil briefly hit its highest level for more than two years on Monday, lifting shares in energy companies, as traders banked on strong demand from the rebounding manufacturing and travel industries.

Brent crude crossed $75 a barrel for the first time since April 2019 before falling back slightly, while energy shares were the top performers on an otherwise lacklustre Stoxx Europe 600 index, gaining 0.7 per cent.

The international oil benchmark has risen around 50 per cent this year, underscoring strong demand ahead of next week’s meeting of the Opec+ group of oil-producing nations.

US manufacturing activity expanded at a record rate in May, according to a purchasing managers’ index produced by IHS Markit. Air travel in the EU has reached almost 50 per cent of pre-pandemic levels, ahead of the July 1 introduction of passes that will allow vaccinated or Covid-negative people to move freely.

“This is a higher consuming part of the year,” said Pictet multi-asset investment manager Shaniel Ramjee, referring to the summer travel season. “And the oil market is pricing in strong near-term demand that is better than previous expectations.”

In stock markets, the Stoxx Europe 600 dipped 0.3 per cent while futures markets signalled Wall Street’s S&P 500 share index would add 0.1 per cent at the New York opening bell.

The yield on the 10-year US Treasury was steady at 1.494 per cent. Germany’s equivalent Bund yield gained 0.02 percentage points to minus 0.154 per cent.

Equity and bond markets have consolidated after an erratic few sessions since US central bank officials last week put out forecasts indicating the first post-pandemic interest rate rise might come in 2023, a year earlier than previously thought.

US shares tumbled last week, while government bonds rallied, on fears of tighter monetary policy derailing the global economic recovery.

Wall Street equities then bounced back on Monday, with a follow-on rally in some Asian markets on Tuesday, as sentiment got a boost from more dovish commentary from Fed officials.

Fed chair Jay Powell, in prepared remarks ahead of congressional testimony later on Tuesday said the central bank “will do everything we can to support the economy for as long as it takes to complete the recovery”.

John Williams, president of the Federal Reserve Bank of New York, also said that the US economy was not ready yet for the central bank to start pulling back its hefty monetary support.

Jean Boivin, head of the BlackRock Investment Institute, said that “the Fed’s new outlook will not translate into significantly higher policy rates any time soon”.

“We may see bouts of market volatility . . . but we advocate staying invested and looking through any turbulence,” Boivin added.

The dollar index, which measures the greenback against trading partners’ currencies and has been boosted by expectations of US interest rates moving higher before other major central banks take action, was steady at around a two-month high.

The euro dipped 0.1 per cent against the dollar to purchase $1.1901, around its lowest level since early April. Sterling also lost 0.1 per cent to $1.3909.



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