As Credit Quality Slips, Bond Investors Need Be Cautious

Photograph by Jeffrey Coolidge

In the late 1980s, Michael Lewis’s classic Liar’s Poker infamously derided Wall Street’s stock traders as “equities in Dallas.” It was the era of swashbuckling leveraged buyout artists and the reign of Michael Milken, when bond guys were kings of the financial universe.

In reality, the two worlds are ineluctably linked: A decline in companies’ abilities to service debt comfortably puts them at greater risk of having to take desperate financial measures, such as diluting shareholders’ stakes to raise money—or worse, bankruptcy. Falling corporate bond prices most often beget falling share prices. Witness 2001-2002 and 2007-2008. So after a year of record debt issuance on record-stingy terms—halcyon days for the corporate bond market—it pays extra to be vigilant about signs of deteriorating credit.

James Gellert, chief executive of Rapid Ratings, a credit-research upstart in New York, laments the market’s fixation on Washington’s budgetary misadventures. “What is rarely discussed,” Gellert says, “is whether U.S. corporations are better- or worse-positioned to withstand the changes happening around them.”

In 2012, companies around the world issued nearly $4 trillion of debt. Stateside, corporate bond yields fell 1.26 percentage points on average to close the year at a record low of 3.55 percent, according to Bank of America Merrill Lynch’s U.S. Corporate & High Yield index. To ladle out precious yield to clients, the roughly 100 short-term bond funds tracked by Morningstar have raised their average exposure to riskier junk bonds and other securities rated below investment-grade to 6.4 percent of total assets, up from 3.7 percent in 2008.

That bullish trajectory runs counter to the prevailing erosion of credit quality. Standard & Poor’s and Moody’s Investors Service are now cutting company debt ratings at their fastest clip since 2009. S&P’s worldwide ratio of ratings downgrades to ratings upgrades climbed to 1.85 last year, from 1.23 in 2011, with defaults rising to 80 issuers, vs. 52 in 2011. ”The gradual reduction in covenant protection and increased issuance in lower rated high yield bonds … are arguably more tangible evidence that the tinder is there for the next credit crack-up,” says Tom Carney, portfolio manager of the Weitz Short-Intermediate Income Fund. “Timing unknown.”

For its part, Rapid Ratings’ proprietary Financial Health Rating tracks over 60 financial ratios (PDF)—spanning sales performance, working capital efficiency, and debt-service management—to rank each company’s health on a worst-to-best scale of 0-100. Historically, 90 percent of defaults have occurred on credits that Rapid Ratings scores 40 or less, placing in its High Risk and Very High Risk zones. The firm was especially prescient about the failure of MF Global; it long rated the brokerage in the 20s—“high risk of nonpayment”—while S&P, Moody’s, and Fitch Ratings all rated MF Global investment grade a week before it filed for bankruptcy.

Gellert finds that U.S. companies are in decreasingly hale health. Rapid Ratings’ U.S. index of more than 3,300 companies started this year with an equal-weighted score of 49.97, having just dipped below 50 after eight consecutive months without an improvement; in that time, six months saw drops.“This steady decline is disturbing and shows that companies are struggling and becoming less-efficient,” he said. “The weaker they are, the more likely they are to be adversely affected by a shock.”

But no one’s much thinking shock, what with corporate balance sheets so flush and the Federal Reserve avowedly long-term loose. Cash for non-financial members of the S&P 500 has grown relentlessly to nearly $1.25 trillion, even as the aggregate ratio of cash to debt on those balance sheets is declining.

Moody’s finds that investors are exacerbating risk levels by buying more junk debt marketed with the lowest protections. Securities that allow the borrower to make interest payments with further debt, instead of cash, are selling at their highest level since 2007, according to Bloomberg data.

You may by now have repressed the memory of how that period ended. Is that wise?

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