Unless you invest in the corporate credit market, it is probably an area of the financial landscape that isn’t on your radar. The vast majority of people focus on government debt, but there could be a big problem brewing in the commercial bond market.
Like seemingly every other area of the economy, companies have borrowed extraordinary amounts of money in the post-2008 low-interest rate environment. Unlike governments, companies have to make money if they ever want to pay back their bondholders.
According to a number of credit market analysts, there could be some big problems coming in the corporate credit market. In addition to declining economic prospects, corporate credit could become the epicenter of a rush on liquidity.
Cashing in the Corporate Credit Piggy Bank
One of the biggest risks is that companies begin to default on their debt.
Carlyn Taylor, the co-leader of corporate finance and restructuring at FTI global had this to say on the state of the market:
“The expansion is pretty long in the tooth and there’s definitely a lot of buildup. The activity level of restructuring is rising, maybe not at the rate of bankruptcies, but the pipeline of companies we think are going to end up in restructuring, based on metrics that we analyze, that volume has gone up. And we’re so busy, which we don’t think is just market share, because we think our competitors are also very busy.”
The fact that corporate credit is now widely owned is another area of concern. It is worth remembering that the perception of rising defaults is what triggered the unraveling of the MBS market in 2008.
A global domino effect could happen again but with much higher stakes this time around.
The Liquidity Problem
Deutsche Bank AG analysts recently wrote that:
“When the cycle turns, the desire to protect returns will send credit investors fleeing to the exit in a market that has no ability to warehouse the risk…We think this next negative spread cycle could easily be the third-most severe on record.”
In plain English, the analysis at Deutsche are saying that a run on the corporate credit market could easily result in a liquidity event that could spill over into other asset classes.
UBS strategists noted that,
“Credit investors have been left somewhat scarred by the whipsaw in prices, with clients indicating market moves have been dysfunctional…The worrying aspect of these spread moves is that they are somewhat divorced from the underlying fundamentals that the market is trying to price.”
The credit markets might not make the same kind of headlines that the stock markets drive, but they have the potential to ruin the asset value party that has been in full swing for nearly a decade.
Needless to say, once the party is over everything will have to go at a big discount.