Simply the Bust

Murray Gunn on May 26, 2023

Bankruptcies are rising, but the bond market still hasn’t got the memo.

Browsing the FT over my morning vanilla latte in the early summer sunshine today (you’re in Essex, not Rome, get on with it: Ed), my eyebrows were raised at an article titled, “U.S. credit squeeze triggers rise in corporate bankruptcies.” Eight companies in the U.S. with more than $500m in debt have gone to the wall this month (filed for Chapter 11 in the lexicon) which compares with a monthly average of only three in 2022 (a 2.618 multiple for those of you keeping track). Twenty-seven corporates identified as “large debtors” (over $500m in liabilities) have gone bankrupt so far this year and that compares with a total of forty in 2022. Clearly, the current deflation of money and credit is having an effect.

Last August, a car drove into the side of my motorcycle. I could see it about to happen and things went into slow motion. Then, bang. Back in 2007, I remember saying to my colleagues on the corporate debt desk at the Abu Dhabi Investment Authority, who were telling us every day that the markets had seized up, that it was akin to watching a car crash in slow motion. Sure enough, a catastrophic pile-up occurred in 2008. This seems to be a similar time.

S&P Global Ratings expect the default rate on speculative-grade bonds to nearly double into 2024, and yet our “downgrade-o-meter,” (the yield spread between the lowest-rated investment grade bonds and those one ranking above) remains stubbornly sanguine, indicating no concern at all about a corporate credit bust.

The chart below shows that the yield spread between junk bonds and those corporate bonds rated AAA has widened since its 2021 low, doubling at the peak in November 2022. However, compared with previous recessionary times, and we are almost certainly heading for another one, this gauge of corporate stress is nowhere near those previous extremes. If, as we anticipate, stock markets are set to decline again, expect corporate debt to become a huge issue.

This is What Debt Deflation Looks Like

Murray Gunn on March 27, 2023

Expect confidence in corporate bonds to plummet.

Normally sleepy Switzerland was the center of attention last week after the shotgun wedding between Credit Suisse and UBS. Both banks didn’t want the deal but the Swiss regulator, Finma, insisted on it taking place, even going so far as changing the law and not allowing UBS shareholders to vote on it. Not only that, Finma changed the capital structure, with Credit Suisse bond holders being wiped out as prices have been written down to zero. Normally, bond holders are first in line to get at least some of their money back.

The so-called Additional Tier 1 (AT1) bonds, also known as contingent convertibles (CoCo), were born in 2013 as European banks began looking for ways to boost their capital ratios. It is widely known that AT1 bonds are risky and that if a bank gets into difficulties the bonds could get converted into equity or written down completely. Nevertheless, the wipe out of Credit Suisse AT1s has come as a shock to the system and now other bank AT1 bonds are being re-priced. This increases the cost of capital in the banking industry as a whole and will contribute to a general tightening of monetary conditions and lending standards.

This is what debt deflation looks like. Bonds become worthless. Sure, the AT1 bonds are a unique form of debt, but underlying all bond markets is confidence. The term credit is derived from the Latin word cred which actually means “believe.” When belief or trust goes, things can get very ugly as was aptly demonstrated by the financial crisis of 2008.

We have highlighted the fact that the corporate debt market has held up relatively well in the bond bear market thus far, but that we expected it to be the next shoe to drop. The Credit Suisse bond situation is a manifestation of that and we anticipate the disappearing confidence to drive corporate bond yield spreads wider. As the chart below shows, European corporate debt has a lot of scope to underperform.

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