7 minute read
In recent months, markets have surged, driven by strong U.S. consumer spending and the belief that the Federal Reserve has stopped raising interest rates and might start lowering them soon. While this optimism is understandable, some underlying issues are emerging.
For instance – as I’ve shared with you before:
· Pandemic-era savings have been exhausted, and credit card debts are increasingly falling into delinquency at alarming rates (read more here).
· Banks are facing a significant challenge with a large amount of risky commercial real estate debt coming due (read more here).
· Global economic issues are worsening, thus sparking a trade war with China that’s becoming inevitable (read more here).
Adding to these concerns is the global corporate debt market.
After many companies refinanced their debt at very low interest rates in 2020, they now face a wave of loans coming due over the next few years, just as the economy might be slowing down. This situation, where two negative factors combine, is often called a "double whammy."
Let’s take a closer look at this issue.
Global Corporate Debt Maturing Over The Next Three Years Is Very Troubling
There’s a huge wall of corporate debt maturing over the next three years - with much of it held by companies with speculative credit ratings (aka high yield or junk) or are just one credit downgrade away from speculative.
To put it another way, a significant amount of 'BBB'-rated debt — the last rung on the investment grade ladder and just one step above a 'junk' rating — is coming due by 2026.
This is happening at a time when borrowing costs have risen sharply due to Federal Reserve tightening, and corporate earnings are declining for many speculative borrowers – especially the small-cap firms.
· To put this into perspective, small-cap stocks are increasingly becoming unprofitable, with about 42% of the Russell 2000 currently posting negative profitability, compared to less than 20% in the mid-1990s, according to data compiled by Bloomberg1.
For instance, firms in the small-capitalization Russell 2000 Index hold a total of $832 billion in debt, with 75% of it—about $620 billion—needing to be refinanced by 2029, according to data compiled by Bloomberg. In comparison, companies in the large-cap S&P 500 Index have only 50% of their obligations due by that time.
And while this is concerning, what worries me more is the potential for 'BBB'-rated companies to trigger problems. Note that a single credit downgrade would push them into the junk-debt category, thus becoming a 'fallen angel' – aka companies that fall from investment-grade to junk status.
And there’s a lot of it. . .
For instance, according to the recent S&P Global Ratings Research2 credit report, about $7.3 trillion of the global corporate debt market they rate will mature over the next 36 months - representing roughly 31.1% of all global corporate debt outstanding, which is around $24 trillion.
Keep in mind Companies usually refinance 12-18 months before their debt matures, meaning they will likely do so over the next year at higher interest rates.
· When a loan matures, the borrower must repay the full balance and any interest due. Since most companies don’t have enough cash on hand, they will refinance the debt with new loans. Think of it like refinancing a home mortgage.
The problem? Well, refinancing at higher interest rates isn’t desirable, and companies would likely only do so if may be forced to.
But the real issue is that most of this maturing debt is held by BBB-rated companies and those below (speculative grade).
And as I mentioned earlier, BBB-rated companies are just one downgrade away from becoming junk. To illustrate the cost difference, the spread between high-yield (junk) interest rates and 5-Year U.S. Treasury rates is over 3% as of May 22, 20243.
And that’s what I’m really worried about. . .
“Don’t Call Me Lucifer”: Beware The Fallen Angels
Now that we have established there’s quite a bit of corporate debt maturing in the next few years – and most held by firms just one credit downgrade away from junk – is this worth worrying about?
Well, yes and no.
On the one hand, billions of dollars of debt issued by BBB-rated companies have been upgraded in recent months as these companies have continued to strengthen their balance sheets. The surge in upgrades has been so significant that some argue it is helping keep spreads, (risk premiums; the difference between corporate debt rates and U.S. government debt rates) low, despite the highest benchmark interest rates in decades.
Meanwhile, according to the Wall Street Journal4, the higher interest rates have boosted corporate earnings as they’re now parking their cash piles into higher-yielding assets (all that corporate money collecting more yield than expenses).
However, on the other hand - the overall corporate outlook relies on a growing economy. And since the start of 2024, economic data has been deteriorating (I’ve written recently about some of this – you can read here).
· Keep in mind that lower growth negatively impacts corporate debt markets because too much debt with insufficient growth prospects is problematic.
As a result, the share of BBB-rated corporate bonds on a "negative outlook or watch" has more than doubled since February 2024, from 2.8% to 5.7%. Meanwhile, the BBB-rated corporate debt on a "positive outlook or watch" has declined, according to Bank of America Global Research5.
Or putting it another way, for the first time since the depths of the pandemic in early 2020, the proportion of BBB-rated bonds – one step away from junk - on watch for a downgrade has recently surpassed the proportion of debt on watch for upgrades.
Some big names that have been cut or are on the chopping block are:
· Paramount Global with $13 billion in debt.
· Charter Communications Inc. with $45 billion in debt.
· And Boeing Inc. with some $46 billion in debt.
So, this trend is worth monitoring as the global debt market could face some distress in the coming year.
Wrapping It Up
So – in summary – there’s a significant amount of debt coming due over the next 36 months. But it’s happening in the face of both declining economic conditions, higher interest rates, and anemic corporate earnings.
Making matters worse, there’s an enormous amount of ‘BBB’-rated debt outstanding. And a single downgrade would plunge them into the junk debt market – which could make their borrowing costs rise dramatically (not to mention certain investors/funds can’t even hold anything below investment grade).
Thus, while things have held up reasonably well over the last two years (since the Federal Reserve began hiking interest rates), the corporate bond market is still at risk of choking on all these potential fallen angels.
So don’t be surprised if it eventually does.
Sources:
3. https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY
4. https://www.wsj.com/articles/companies-belly-up-to-cash-buffet-in-five-charts-cf293394
Disclosures:
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Russell 2000 Index The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.
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