Who’s Going to Buy All of This Junk?
The title of this posting may conjure up the image of a beleaguered husband prior to an extensive garage sale, but it is actually a valid question when one looks at the current U.S corporate bond market. “Junk” is an investment term that describes high yield corporate bonds issued by financially challenged corporations. Because of the greater risk of missed interest and principal payments by the issuers of this debt, investors demand higher yields. This, of course, costs the borrowing company more money, so these firms struggle with servicing their debt much more than higher quality “investment grade” bond issuers.
Ratings agencies like Moody’s, Standard & Poors and Fitch publish researched opinions and ratings on many corporate debt securities and these ratings are closely watched by investors. Indeed, many large investors such as banks, pension funds and insurance companies are required to limit their holdings to only investment grade debt securities, so staying above the high yield dividing line is very desirable for corporate treasurers. While many debt securities are classified as “junk” at the time they are first issued, some investment grade bonds are re-classified into the high yield universe due to a decline in their business prospects. These downgraded companies and their debt securities are known as “fallen angels”. While the original corporate issuer is not immediately penalized by the downgrade, owners of these bonds will generally see a concurrent loss of principal as the bond’s on-going trading price must adjust to compensate for the higher level of risk now being assumed by a prospective purchaser. It does become more difficult for the “fallen angel” corporations to issue debt in the future, however, so businesses will do what they can to avoid having their bonds downgraded.
The Covid-19 outbreak has imposed tremendous stresses on corporate cash flows. Likewise, the severe drop in energy prices has negatively impacted the fortunes of oil/natural gas exploration and production companies. To make matters worse, these most recent business developments have taken place at a time when the level of U.S. corporate borrowings was already at record levels. As of April 30, 2020, about 44% of outstanding U. S. Corporate debt was rated BBB, only one rating notch above junk.
The big question for the near future is, “Given the cash flow stresses caused by Covid-19, how many of these borderline investment grade bonds will become fallen angels?” Vanguard estimates that as much as $400 billion of BBB bonds will be downgraded into “junk” territory. When this is contrasted with the $130 billion of BBB downgrades that took place in the Great Recession of 2007-2009, one has to wonder if the high yield market has enough buyers. It could get very ugly for the owners of these fallen angel bonds when there is such a huge imbalance between buyers and sellers. The sellers who are forced to liquidate because of their regulatory mandates may only be able to find buyers at severely depressed prices.