There’s never a good time for a wave of corporate defaults. As the global economy is battered by the new coronavirus pandemic, questions are growing about whether a vast pile of risky debt can be allowed to implode.
Regulators in the US and Europe have been warning for more than a year about a buildup up of speculative-quality debt and its potential to damage everything from banks to the job market. Companies have racked up around $3 trillion of these leveraged loans—a loose term that refers to junk bonds and loans that have a higher risk of default. Much of the debt is concentrated in the US, though the EU has exposure, too.
A reckoning is looming, unless officials widen their already unprecedented support for the economy to include these risky borrowers as well. Forecasters at Moody’s Investors Service think a severe recession with a peak in US unemployment of around 10% would spark a default rate of 16% for lower-grade borrowers around the world. (In February, the default rate was 3% and it reached about 12% during the last financial crisis.)
With businesses shuttered and industry slumping, experts have mixed views on whether the economy can withstand another blow. As government officials lock down movement to contain the Covid-19 outbreak, US jobless claims have set records for two weeks in a row.
In a sign of fear, risky bond yields spiked relative to Treasuries to more than 10 percentage points at the end of March, the widest spread since recession in 2009. Analysts say the market is pricing in default rates of around 12%.
“A crisis is not the time to get rid of anyone, it would only make things worse,” Roberto Perli, head of global policy research at Cornerstone Macro and a former staff member at the Federal Reserve, said on Twitter. “These are issues better addressed in normal times.”
In the US, the epicenter of much of the worrisome debt, the government created a $2 trillion package to support the economy, and the Federal Reserve set up a series of facilities aimed at investment-grade securities to keep credit markets churning. These efforts contain support for workers, small enterprises, and corporations with higher credit ratings, but not for those whose credit quality is shakier.
Putting taxpayer money on the line to support larger corporations considered a higher risk of default, some of which weren’t viable even before the crisis hit, could be a political lightning rod. Bank for International Settlements economists say the world’s equity markets’ share of zombies—companies that don’t earn enough money to cover their interest expenses—has been rising since the mid 1990s.
“What do you do with a company that’s basically not viable anymore?” said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research. “Should the taxpayers really be risking money on these guys?”
Companies typically continue operating even after a default and a debt restructuring, but a wave of leveraged loan and junk bond defaults would still mean more workers losing their employment at a time when the economy is already hemorrhaging jobs. When commerce finally resumes, a raft of defaults could mean fewer businesses still around to provide work.
Yet protecting these borrowers and investors who gambled on risky debt poses a moral hazard by incentivizing reckless behavior. Over-indebted companies and their investors didn’t cause the pandemic, but propping them up would mean taxpayers are shielding them from losses, while investors walk away with the financial gains.
The junk bond market may not satisfy another criteria for bailouts: systemic risk. Whereas banks were deemed too big to fail in 2008, leveraged loan defaults, even in the double digits, aren’t necessarily going to cause the financial system to collapse. Some investors are already bullish on junk bonds, and lower-rated companies are again raising money.
“It’s hard to argue they pose a systemic problem,” Allison Schrager, a senior fellow at the Manhattan Institute, said of leveraged loans. “I am not sure there’s much justification to keep them going just to lower unemployment.”
The IMF made a dire warning six months ago: A slowdown half as severe as the 2008 collapse could put some $19 trillion of debt at risk, according to the organization’s financial stability report. Heavy corporate indebtedness could exacerbate the next downturn, the IMF said, leading to higher unemployment, and cause banks to pull back from lending.
Corporations have binged on debt as central banks in the world’s financial capitals have sought to keep a lid on interest rates. Investors, from hedge funds to pensions, have responded by taking ever more risk to get an adequate return. This speculative debt is sometimes used to fund corporate acquisitions, or by private-equity firms looking to purchase public companies.
“Over the last 10 years there’s been a lot of leverage built up in companies that are not as strong, and that are highly leveraged,” said Atsi Sheth, managing director at Moody’s. The Cares Act, as the emergency spending and lending package is called, doesn’t directly funnel money into these risky junk-rated borrowers.
“The very strong will probably be supported by all of this liquidity and aid,” Sheth said in a telephone interview. “But the weak, even with that assistance, first it may not trickle down to them, and second, it’s not enough for what they need.”
About a quarter of the loans that are at higher risk of default are held by collateralized loan obligations (CLO), according to the Financial Stability Board (FSB). CLOs are like investment funds: They raise money by issuing bonds and investing the proceeds in junk loans. Some of the bonds they issue get paid first and are senior to the other ones that are riskier and won’t get paid if the underlying loans default. The riskier the bonds are, the more they yield.
In a world where fewer assets offer much of a return, the demand for CLOs has soared. These products can be stuffed with loans from buyouts led by private-equity companies like KKR and Apollo Global Management, whose founders are billionaires. In the US, more than $60 billion of risky loans and junk bonds last year were used for share buybacks and to pay dividends to investors, according to the IMF. That kind of financial maneuvering, while lucrative for private-equity companies and stock investors, can make companies more susceptible to default.
If the Federal Reserve started buying junk bonds or dreamed up some other way to help speculative-grade companies, it could be a quick and effective way to lower market stress, but it would also create dangerous incentives for risk taking. “In the leveraged loan market, they have long levered up these balance sheets at the expense of the bond holders and issued tons of debt,” Schwab’s Jones said. Supporting the leveraged loan market risks “bailing out private-equity billionaires.”
A large group of economists, meanwhile, earlier urged Congress to bail out workers before companies. The academics point out that companies can continue operating even while they’re in bankruptcy—it doesn’t necessarily result in liquidation. They argue that workers, many of whom are the most affected by shelter-in-place orders, are the ones the government should be helping.
“When you bail out a large corporation, the people you are actually bailing out are the investors in that corporation,” according to the letter signed by more than 200 economists from institutions including Stanford, University of Chicago, and Massachusetts Institute of Technology. “Bailouts allow investors to keep all the profits in good times without bearing the losses in bad times. Instead, bailouts impose losses on taxpayers, including those most in danger of losing their paychecks.”