As US corporate bond issuance hits new levels, experts flag the risks around increasing leverage at a time of struggling economic growth. Any spike in inflation also risks a rise in interest rates, they say.
Rock bottom interest rates have made it cheap for companies to borrow ever since the financial crisis when governments set about kick starting the recovery. However, the number of US companies issuing debt to tap historically low borrowing costs has just reached unprecedented heights. According to figures from data provider Refinitiv, US corporate bond issuance has hit US$1.919trn so far this year, surpassing the previous annual record of US$1.916trn in 2017 with months of the year still left to go. For companies facing the cocktail of challenges unleashed by COVID-19, cheap borrowing offers one silver lining. However, experts are increasingly warning of perils ahead.
The swathe of top rated US corporates bringing bumper deals to market (and juicy fees for investment banks) in recent months include Coca Cola, Walt Disney and Ford, while Amazon locked in some of the lowest borrowing costs ever secured in the US corporate bond market in June. Elsewhere, media giant AT&T has issued around US$17bn of debt with maturities stretching out 40 years. The strategy allows the company to fund the repurchase of debt that was set to come due over the next five years and take advantage of historically low interest rates, explained John Stephens, AT&T Senior Executive Vice President and CFO speaking on a recent earnings call.
“We’ve been active in the bond market, rates are low, demand is healthy, and we [are using] this opportunity to issue about US$17bn in long-term debt at rates significantly below our average cost of debt. This allowed us to materially reduce our near-term debt towers, making our debt obligations for the next few years very manageable,” he said. With the company’s ten-year bond yielding about 2% in August, Stephens noted it was “the lowest it’s traded” since he joined the company “in the early 90s.”
Drivers
The issuance bonanza is being driven by policy moves by the Federal Reserve. As well as cutting interest rates, this has included a promise to buy corporate bonds for the first time. It led to borrowing costs sharply falling and has fired up the market with blue chip and lower-quality companies rushing to issue debt as well as opportunistic borrowers seeking to lock in cheaper funding. Nor is the pace set to slow anytime soon, as bankers urge treasury departments to secure their funding needs ahead of the US election, and anticipated market volatility.
Low borrowing costs and companies seeking to extend the maturity of their debt are not the only drivers, however. Starved of yield, investors are piling in, explains Campbell R. Harvey, Professor of Finance at Duke University, and an advisor to Man Group and Research Affiliates. “Investors are not attracted to government bonds because rates are near zero or negative. They are more likely to reach for something risky and this is stoking demand for corporate debt which is helping to moderate credit yields.”
He also flags dangers on the road ahead. High borrowing is a concern for companies if their earnings remain depressed and they can’t service the interest costs. Vulnerable sectors include travel and hotels, or those facing disrupted supply chains.
The prospect of a rise in inflation in turn triggering a rise in interest rates is another worry. “A surprise rise in interest rates is potentially devastating for companies because they will have to refinance at higher rates. The market doesn’t expect a surge in inflation, but it is a major risk because if inflation goes up, interest rates will likely go up too.”
Harvey also points out that some companies hit hardest by the pandemic have sold bonds secured against their assets. These could be taken if the company struggles to meet commitments should interest rates go up or the recession bite harder. For example, airlines have written aircraft and flying routes into covenants while cruise operators have pledged ships that will be called in if companies can’t repay investors. “Companies have pledged different types of collateral written into covenants which might have to be offered up if debt service costs go up or if go into another recession,” he says.
Concluding with advice for treasurers, he urges treasury departments to actively manage their risk, weighing up different scenarios. “Increased leverage generally means increased risk. Don’t be misled by low debt service costs today. The time to increase leverage is when you are confident that the economic outlook is robust, and right now there is considerable uncertainty.”
