INVESTORS have been reminded in the past two months that market shocks can engulf even the biggest and — as judged by credit rating agencies — least risky of corporate borrowers.

Petrobras has been hurt by the falling oil price and a Brazilian political scandal. Trading house and miner Glencore found its business model out of favour. Volks­wagen admitted to cheating emissions tests and Valeant had obscured a partner responsible for significant drug sales.

Yet can the problems just be brushed off as oddities with little wider significance? Or do they point to a broader reassessment, a return of credit risk after years in which the actions of central banks were the most important factor when it came to assessing the cost of borrowing?

“Investors just got two huge wake-up calls,” says one veteran debt banker, in reaction to the drop in prices for VW and Glencore debt. “It’s a timely reminder that in the extremely low-risk world of quantitative easing asset values are all over the place.”

Since 2009 central bankers around the world have cut interest rates and launched large asset purchase programmes to stimulate economic growth by lowering borrowing costs for governments, companies and individuals.

Companies have responded to the opportunity by raising debt. For instance, last year global corporate bond issuance totalled a record $3.5tn, according to Thomson Reuters, up from $2.1tn in 2008. Investors have been enthusiastic buyers, prepared to risk their capital for a very low fixed income, by historical standards. The highest quality corporate borrowers also compared favourably to some governments struggling under large debt loads.

Investors dealt warning blow as central banks’ support of cheap money nears end of road. The

Federal Reserve is yet to raise interest rates, and it isn’t normally until after rates rise that troubles

for borrowers begin

So for those who remember previous scandals, such as the collapse of Enron and WorldCom more than a decade ago, corporate problems are just an indication that the credit cycle is starting to turn. Weak economic growth means companies have struggled to lift sales, and may be reaching the limit of their ability to increase earnings.

“A lot of people are recognising we are closer to the end of the credit cycle than the beginning,” says Adam Smears, head of fixed income research for Russell Investments.

As lenders reassess the ability of companies to pay, they demand higher interest rates, or a greater risk premium ‘spread’ over government bond yields. The rise in borrowing costs can then put further pressure on the weaker borrowers. There was $3.5tn record total for global corporate bond issuance last year, according to Thomson Reuters.

Lists maintained by both Standard & Poor’s and Moody’s of the weakest companies in their respective coverage universes have started to swell. S&P counts 167 issuers with some $216bn in debt outstanding among its lowliest rated groups. Yields for these borrowers in turn have soared, hitting a high of 8.2pc at the start of October from a low of 5.9pc in March.

Analysts with Merrill Lynch call it ‘a slow moving train wreck that seems to be accelerating’ as the sell-off engulfed a larger and larger number of companies. What started as weakness in coal- and crude oil-linked debt spread to paper issued by telecoms, auto, media and pharmaceutical companies, despite steady, albeit lacklustre, economic growth.

“You don’t have the indicators that we are at the end of the credit cycle besides the fact that the market is a lot cheaper,” Andrew Susser, a portfolio manager with MacKay Shields, says. “There’s no indication of a cash crunch and people are still looking for spread product.”

Indeed, the central bank dilemma remains. Investors who would normally be worried about the amount of debt taken on by companies, and the effect of cheap money, also point to the nature of the economic cycle. The Federal Reserve is yet to raise interest rates, and it isn’t normally until after rates rise that troubles for borrowers begin.

“Absent the central banks, we would be in the later stages of a credit cycle,” says David Blake, chief investment officer for Principal Global Investors, an asset manager. Yet while he sees a slow deterioration in credit metrics, he continues to find investment grade credit attractive. “We’re in the eighth inning of an extra inning game,” he says.

For the moment, the rise in junk debt yields has been enough to entice investors back into risky paper — high-yield US corporate bond funds have counted more than $7.5bn of inflows in the past four weeks, according to Lipper.

Risk premiums for lower quality debt remain wide despite the shift in flows and that fact, investors say, underlines the disconnect between equities and bonds, the latter pricing in an economic downturn that has yet to materialise.

Investment cycles, after all, are based on perceptions as much as changes to underlying business conditions. The question, then, is perhaps not when company creditworthiness changes, but when the assessment of credit risk shifts.

Published in Dawn, Business & Finance weekly, November 9th, 2015

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