Cracks in the credit market are starting to widen

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The great government bond slump of 2023 is reaching the point where bankers and investors are shuffling in their seats and eyeing each other nervously, wondering when something will snap.

It is easy to see why. The drip-drip decline in government debt prices has become a torrent in the past three weeks or so, demolishing the value of many a bond portfolio in its path. Benchmark yields on 10-year US Treasury bonds stretched above 5 per cent on Monday for the first time since 2007 — another big round number toppled. 

Given the scale of the move, it is natural to wonder whether something foul is bubbling up in this mess, particularly with the memory of the UK’s short, sharp gilts crisis last year still fresh in the mind.

“Rising global yields led by the US have sparked fears that ‘something’ will soon break,” wrote Davide Oneglia of TS Lombard this week. “But a wide range of stress indicators show that moves have been orderly and that markets are less nervous than when the UK crisis erupted.”

Volatility is elevated, but not extreme, he pointed out. It is fairly well contained to the US market. The mood is more of calm resignation than of panic. Even so, if you listen carefully, you can hear the faint tinkle of alarm bells in the corporate debt markets.

Economists have warned for months that at some point the march higher in bond yields, and the corresponding rise in borrowing costs for everyone from households to governments, will start to bite. This awkward reality of the higher-for-longer interest rate environment is now becoming clearer.

Government bond issuance from emerging markets has collapsed to around $2bn this month, according to data from JPMorgan, having been comfortably in double figures for most of this year. Companies are also baulking at the exorbitant borrowing costs, making this the slowest October for US corporate debt issuance in more than a decade.

And the debt that is already out there is creaking. Rating agency Standard & Poor’s noted this month that the global tally of corporate bond defaults rose to 118 in September — nearly double the total at this point in 2022 and well above the usual average for this time of year, which is 101. The European total is the second highest since 2008, beaten only by 2020, which was grim for obvious reasons. 

An additional curiosity: S&P pointed out that more than half of defaults globally in September were so-called distressed exchanges, where shaky companies buy back their own bonds at depressed prices. Paul Watters, head of the rating agency’s European credit research, said when this is done by weak companies, and with some element of failing to honour promises they had made to lenders, it is a distress signal.

Many of these companies have been operating under unsustainable capital structures for a while, he said. They may have assumed, for example, that they can keep on rolling over debt at affordable rates. Higher costs of financing and a weaker economy, especially in Europe, are putting those models under unbearable strain. As a result, “companies are trying to buy debt back and buy a bit more time”, he said.

This is not S&P’s first warning of the kind. Back in June, it pointed to the rise since 2008 in selective defaults, where a company will fail to pay back one of its bonds, for example, but stay current on others. Selective defaults account for about half the total this year, it said — a lower proportion than in 2022 but still well above the 25 per cent rate that prevailed in 2008.

This is alarming because once companies get a taste for it, they can easily become what the rating agency calls “repeat offenders” on a “slippery slope”. Companies that take this path have a 35 per cent chance of defaulting again within two years, it calculates.

Tatjana Greil Castro, co-head of public markets at credit-focused investment firm Muzinich, also highlights the rise of amend-and-extend transactions — or, she said, “if you are being less polite, amend and pretend”.

Companies tell investors such as her that they are struggling to pay back their debt — maybe they are unable to borrow new debt to repay it at today’s much higher prices. So instead they seek agreement to push the maturity of outstanding bonds further out in to the future. “What’s my alternative?” she asked. If she refuses, the company might enter a hard default, and she might end up getting 30 cents on the dollar. If she agrees, she can hope the bonds retain their value of, say, 80, with at least a chance she will be repaid the full 100 further down the line.

All this strain does not necessarily end up as a disaster for corporate bond holders, because they are reliant on two things: the underlying government debt markets, and the slice of extra yield on top for company risk, or credit spread. If an economic downturn does arrive on a scale big enough to bring lots more defaults, government bond prices should in theory climb, so returns are propped up even if the credit spread blows out. 

Still, in a way, all the hand-wringing around what will snap is a little misplaced. The stress is already here if you look for it.

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