Rising Rates and an Impending Credit Dislocation
We are at the 3-year anniversary of March 23rd 2020, the day on which the stock market hit its low during the beginning of the COVID pandemic. During the pandemic and in the following years, as a result of historically low interest rates, many companies piled debt onto their balance sheets. Today, we are faced with a rising rate environment and we may be nearing a key inflection point within corporate debt markets, where we transition from uneasiness to stress, from accommodative to restrictive, from status quo to dislocation. Cheap financing is no longer readily available. The increased cost of refinancing might be enough to cause a mass migration of credit ratings to the downside and in extreme cases, cause defaults.
In this piece, we will consider the current state of the corporate balance sheet and the potential for a credit dislocation. Then we’ll discuss what types of managers may benefit during a credit dislocation and how allocators should be thinking about the current credit landscape.
Simply stated, growth since the pandemic has been at least partially fueled by debt. Many companies used financing to get through the early days of the pandemic to meet basic spending. More recently, when it became clear that there would be a future increase in interest rates, many companies rushed back to debt markets to take advantage of cheaper financing while they still could. Corporate debt rose from $16.3 trillion just before the pandemic to $19.8 trillion at the end of 2022, based on data provided by the Federal Reserve. Similarly, according to data from the Institute of International Finance, the debt of non-financial institutions has grown from 76% of total global gross domestic product in 2007 to 98% as of 2022. This data, covering the period when rates were initially cut following the GFC until present day, paints a picture that not only are debt levels high on an absolute basis, but corporate debt is growing at a rate that far outpaces GDP growth. Our belief is not that debt-fueled growth leads to crisis indiscriminately, but rather that the level of debt at least increases the probability that corporate credit markets could experience elevated volatility, extreme credit events and credit dislocations over the short to medium term.
It is intuitive to next consider the effect that rising rates will have on balance sheets and how those effects will reverberate into global markets. The rate increases that started in 2022 have been among the most violent and accelerated we have seen in recent history. Not only are rates increasing from historical lows, but according to S&P global ratings, the pace of interest rate increases has been faster than at any time over the past four decades. Most importantly, the rate increases have been faster than market participants first anticipated, introducing volatility to the equity and credit markets.
Cumulative change in federal funds rate since start of initial rate increase
Corporate debt is typically fixed rate and as a result, the higher rates won’t be immediately experienced by many borrowers. Instead, at first it appears that higher rates have mostly impacted equity valuations by increasing the discount rate used for valuing future cash flows. But gradually, companies that require capital will have to face a decision as debt matures, that is, refinance at much higher rates, or tap into other non-traditional capital sources. Either option would likely negatively impact company earnings by increasing interest expense and therefore, have negative implications on shareholder’s equity.
The figure below shows the maturity distribution for corporate debt until 2027. Assuming financing costs remain high, which we believe is probable, this can provide a rough timeline for when higher rates will start to flow through and increase corporate borrowing costs.
Corporate debt maturities, includes bonds and loans and credit facilities rated by S&P Global
Not only are rates increasing but the spread, or additional pick up in yield over base rates, are also increasing. Credit spreads have continued to widen from very tight levels observed in 2021 towards their long-term averages, though they remain far off from their highs. Flow data suggests that most investors still favor the relative safety of shorter duration and government debt. This suggests that corporate spreads could still increase, until investors feel like they are being appropriately compensated for the additional credit risk. This would only increase refinancing and future borrowing costs and further negatively impact already deteriorating credit fundamentals. Heading into 2023, credit quality downgrades had far outpaced upgrades and defaults had ticked up to close to 4% from 1.4% a year earlier. The increases in defaults and downgrades will broadly cause spreads to further widen. The combination of wider spreads, rising rates, and higher debt levels are strong forces that can compound on each other and send credit markets into a spiral where there is little liquidity and available financing. These tight credit cycles could eventually trigger credit dislocations.
ICE BofA US Corporate Index Option-Adjusted Spread
Considering this backdrop, it is not surprising that the yield curve is inverted. An inverted yield curve is one of the most effective indicators of a coming recession. Specifically, the past six times the two and ten-year yields inverted, a recession occurred within eighteen months on average. What is exceptional about this particular inversion isn’t just the duration of time that the curve has remained inverted (since July 2022) but the magnitude of inversion. The spread between the two-year and the ten-year treasury is on track to close at the deepest inversion the markets have seen in more than four decades.
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
When looking at the credit market, it is not a matter of “if” there will be stress, rather when and how will that stress play out. Companies will have to make hard decisions to either maintain their growth or preserve the quality of their balance sheet.
The trends outlined in the previous section have shown no sign in reversing. In fact, some may accelerate. For example, interest rates are expected to increase, there is no sign of a less hawkish fed. In his most recent remarks, Fed Chair Jerome Powell reiterated the fed’s intent to potentially increase the speed and amount of interest rate hikes. The Fed seems committed to moving forward with higher rates until they see an impact on inflation data. So base rates will increase.
Attempting to predict the timing of a credit dislocation (or any market drawdown) has proven to be a fool’s errand for most forecasters. But given the data outlined above, there is plenty of reason to be cautious when allocating to credit. Watching credit spreads can be informative when trying to be tactical in asset allocation. Credit spreads can at least can suggest when valuations offer a certain margin of safety, but nothing can replace the work of fundamental analysis.
When considering manager allocations, it is reasonable to believe that managers with proven abilities to earn alpha in volatile markets and credit dislocations could help provide benefits to overall asset allocation. Although anecdotal in nature, we at Crystal, have heard from many of our platform multi-strategy managers that they have bolstered up their credit and distressed debt teams to take advantage of what they believe is an impending credit dislocation. Additionally, our distressed debt strategy managers have expressed that they expect there to be many more opportunities over the coming 12 to 24 months. These allocations can be important tools to navigate volatile markets and can introduce uncorrelated allocations that can help hedge large-scale market drawdowns.
When considering the macro data, a major credit dislocation seems unavoidable. Excess debt combined with rising rates, widening spreads, increases in downgrades and defaults, paint a picture that there will be more volatility in credit markets. It will be very important to allocate to managers that have a proven track record of taking advantage of credit dislocations and finding opportunities within stressed markets.
- Corporate borrowers squeezed by rising rates | AP News
- The World's Most Indebted Companies 2023 | Global Finance Magazine (gfmag.com)
- Corporate borrowers squeezed by rising rates | AP News
- Investors pull near record sums from corporate bond ETFs | Financial Times (ft.com)
- Yield-Curve Inversion Is Getting Even Steeper. It's a Recession Signal. | Barron's (barrons.com)
- 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y) | FRED | St. Louis Fed (stlouisfed.org)
- Fed still up in the air on whether to accelerate rate hikes, Powell says | Reuters