What happened when Debt is Cheap?

There has been a record pace of credit-rating upgrades, with nearly twice as many upgrades of junk-rated companies compared with downgrades by S&P Global Ratings this year. That’s a reversal from last year, when more companies were lowered than raised up the credit scale.

Reason? Cheap financing is a reason given by the credit-rating firms such as Moody’s Investors Service when they justify the potential creditworthiness of borrowers.

As an illustration, $500 million offering of junk bonds from MicroStrategy Inc., with proceeds going toward buying Bitcoin. How Moody’s justified its Ba3 rating, i.e. investment grade bond?

“Leverage is extraordinarily high, the company has a very low cost of borrowing,” which “enables strong interest coverage as well as free cash flow generation.”

The circular logic of good times begetting good times, is being applied throughout the $10 trillion U.S. credit market.

Fitch Ratings just cut its high-yield default expectation for the end of the year to 1%, which would be the lowest since 2013 and could even challenge the 0.5% mark set in 2007.

Junk-rated companies are paying the lowest rates ever — yields hit a record low 3.84% on 2021-06-14 — to borrow for the longest period on average since 2014. Companies are borrowing money at a record pace in response to the escalating demand. Aside from refinancing more costly debt, borrowers are using money they raise to pay dividends to their private-equity owners, buy other companies, repurchase stock, you name it.

Earnings growth is tremendous for now but destined to fade along with the pandemic. Companies are taking bigger risks given the market’s preference for future returns over safety. Meanwhile, the Federal Reserve says inflation is transitory, but a growing number of economists and central bankers disagree.

As Deutsche Bank analysts led by Peter Hooper wrote in a recent note, “Never before have we seen such coordinated expansionary fiscal and monetary policy. … This is why this time is different for inflation.”

If they’re wrong, however, and bond markets are telling a disinflationary story ahead, that may be even more worrisome for corporate credit, which relies on fast enough growth for corporations to grow into their capital structures.

Inflation is bad for bonds. Deflation is sustained falling of overall prices over months and years. It is perceived to be “bad” as it squeezes companies and makes it harder to pay off old debts.

Disinflation is not deflation. Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation. It is a temporary slowing of the pace of the price inflation and is used to describe instances when the inflation rate has reduced marginally over the short term. The danger that disinflation presents is when the rate of inflation falls near to zero, as it did in 2015, it raises the specter of deflation.

Reference

Bloomberg, 2021-06-15, “Everyone’s a Rising Star When Debt is Cheap”