Corporates Surpass ’07 Mortgage Bonds as Risk Escalates

By Lisa Abramowicz and Sarika Gangar

March 18 (Bloomberg) –- Corporate debt is accounting for the biggest portion of the U.S. bond market ever, with $9.8 trillion of debentures surpassing the 2007 peak of the mortgage-securities boom that triggered the financial crisis.

Debt issued by companies from Verizon Communications Inc. to Caesars Entertainment Corp. made up almost 25 percent of the $39.9 trillion in U.S. bonds outstanding at year-end, up from 19 percent five years earlier, according to data published March 14 by the Securities Industry and Financial Markets Association. Outside the $11.9 trillion of Treasuries, corporates are the largest component of the world’s biggest debt market.

Obligations are mounting as the Federal Reserve pulls back from more than five years of easy-money policies that spurred the borrowing glut. With economists forecasting benchmark yields will rise, that’s raising concern companies facing $3.5 trillion of maturities by the end of 2018 will find it more costly to refinance, similar to what U.S. homeowners faced six years ago.

“The market is getting more and more similar to that 2007 time period,” Jody Lurie, a corporate credit analyst at Janney Montgomery Scott LLC in Philadelphia, said in a telephone interview. Investors “are going down in credit quality to the point that it’s detrimental to potentially getting back the principal.”

Fed Stimulus

The Fed has funneled more than $3 trillion into the financial system since 2008, pushing bond yields to record lows as it spurred the world’s biggest economy out of recession. While the central bank is slowing monthly purchases of Treasuries and mortgage debt, it will likely keep overnight borrowing rates at about zero through at least mid-2015, economists surveyed by Bloomberg predict.

With the stimulus in its sixth year and the economy showing signs of accelerating growth, investors from hedge funds to retirees are delving further into U.S. speculative-grade corporate debt.

Yields on junk bonds have fallen to 6.2 percent, 2.8 percentage points less than the average of the past decade and 0.21 percentage point from the all-time low reached last May, Bank of America Merrill Lynch index data show. Buyers demanded 3.78 percentage points more than similar-maturity Treasuries to own the riskiest bonds on March 5, the least since 2007, according to the data.

Taking Advantage

“The borrowing costs are so low that corporations feel that they have to take advantage of it,” James Kochan, Wells Fargo Funds Management LLC’s chief fixed-income strategist, said in a telephone interview. “Corporations have eliminated high cost debt with low cost debt and they’re healthier because of that.”

Companies have more than doubled their dollar-denominated debt since 2003, when $4.6 trillion of notes accounted for 21 percent of the U.S. bond market, according to data compiled by Sifma. The volume of corporates at the end of 2013 exceeds the $9.4 trillion of mortgage securities reported in 2007, at the height of the boom, when property debt represented 29 percent of dollar-denominated bonds, the industry group’s data show.

Mortgage securities accounted for 22 percent of the U.S. bond market at the end of 2013, Sifma data show. Government debt was the only corner of the market bigger than corporates.

Weaker Protections

Some junk-bond investors are forfeiting protections such as restrictions on how much more debt companies can raise, with covenants on North American notes at the weakest level since at least January 2011, Moody’s said in a March 11 report. A gauge of covenant quality that increases as investor protections deteriorate climbed to 4.36 last month from 3.84 in January, reversing three months of improvement. The ratings firm measures covenants on a scale of 1 to 5.

While companies are bolstering earnings as the U.S. economy expands, they’re also increasing debt loads, keeping their leverage relatively stable since September 2012, Bank of America Corp. credit strategists said in a March 11 report. They sold a record $1.52 trillion of dollar-denominated bonds last year, 42 percent more than the annual average during the previous decade, Bloomberg data show.

Investment-grade companies will probably become less-creditworthy this year as they boost borrowings used for stock buybacks and acquisitions, the Bank of America analysts wrote.

Record Offerings

Verizon, the second-largest U.S. phone company, issued the biggest corporate-bond deal ever in September when it raised $49 billion, almost triple Apple Inc.’s previous record of $17 billion offered in April, Bloomberg data show. The company followed up with a $4.5 billion sale this month to help repay higher-cost debt.

Companies will face $3.5 trillion of dollar-denominated debt coming due through the end of 2018, with $885 billion of the maturities in 2018, according to a Feb. 28 report by Standard & Poor’s. The growing refinancing needs will coincide with increasing borrowing costs, as economists surveyed by Bloomberg expect 10-Year Treasury yields to increase almost a percentage point to a median 3.63 percent in the second quarter of 2015 from 2.68 percent today.

“Corporate issuers could find themselves with rising credit costs and fewer refinancing options,” S&P analysts led by Diane Vazza in New York wrote in the report.

Scaling Walls

Before the refinancing wave of the past four years, junk-rated borrowers in 2010 had faced $1.2 trillion of maturing debt over a five-year period. Those maturities were whittled down after $1.3 trillion of speculative-grade issuance in the U.S. since March 2010, Bloomberg data show.

The mortgage crisis that prompted the Fed to expand its balance sheet to more than $4 trillion was exacerbated by a shadow banking system of commercial-paper conduits and collateralized debt obligations that seized up. By 2008, mounting losses on home loans triggered JPMorgan Chase & Co.’s emergency acquisition of Bear Stearns Cos. and the collapse of Lehman Brothers Holdings Inc. and led to more than $2 trillion of writedowns and credit losses by banks globally.

New rules written since 2008 have sought to bolster lender balance sheets while curbing leverage and outsized risks taken in derivatives markets. While signs of such systemic risk haven’t returned to pre-crisis levels, market observers including Fed Governor Jeremy Stein have raised concern that the corporate-debt market is showing signs of a bubble.

Stein has said some credit markets, such as corporate debt, show signs of excessive risk-taking, while not posing a threat to financial stability. Fed Bank of Dallas President Richard Fisher, a former managing partner of a fund that bought distressed debt, said in a January speech that he’d “have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy.”

“Things seem somewhat calm, but that’s part of the difficulty with this job is trying to predict what might happen,” said Sabur Moini, a high-yield money manager at Payden & Rygel in Los Angeles. “You just don’t know when it might happen and what the magnitude might be.”

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