Fear of ‘crexit’ doesn’t hinder mounting leverage: S&P

During the past several years of rock-bottom credit prices, the stock market routinely sold off on any sign that the U.S. Federal Reserve might lift interest rates.

Former Fed chief Ben Bernanke signaled an intention to do this back in 2010, and the market acted like a wailing baby cutting its first tooth. If the Fed signaled it would keep rates low, the market rallied.

Wall Street turned out to be wrong. Artificially low rates were supposed to be only a temporary move to get the economy moving again, not the new normal. And these bottom-of-the-barrel rates, while good for things like taking out a fixed-rate mortgage, may be doing more harm than good.

At least that’s one key observation by S&P Capital IQ, which in its 2016 Global Corporate Debt Demand report flagged lower rates worldwide as unhealthy.

Monetary-policy easing has helped increase financial risk, with growth in corporate borrowing far outpacing the global economy, the study said.

It’s unsustainable.

“Favorable financing conditions, such as abundant debt funding and low interest rates, have elevated prices for financial assets as investors searched for yield,” the study said. “This creates conditions for greater market volatility over the next few years due to lower secondary-market liquidity, with credit spreads for riskier credits and longer duration assets being most exposed.”

Highly leveraged

Nowadays, more companies fall into the highly leveraged bucket, defined as greater than a 5x debt-to-EBITDA multiple. China is a trouble spot as a heavy borrower.

This bleeds into the PE world in a number of ways. For GPs running credit funds, it could affect where they choose to invest and the prospects for the returns on their investments. Credit conditions will dictate interest rates on assets and the amount of risk associated with returns.

For LBO specialists, these macro trends may affect both the cost of putting leverage on a deal and the blend of loan types in the capital stacks of portfolio companies.

At last check, average debt multiples for U.S. leveraged buyouts fell to 5.29x EBITDA in the second quarter from 5.35x EBTIDA in the year-ago quarter, according to S&P Capital IQ data.

All told, S&P Capital expects corporates globally to seek up to $62 trillion in debt by 2020. About 40 percent of that, $24 trillion, will be new debt and $38 trillion will go to refinancing. China could consume $28 trillion, or 45 percent of global debt demand, followed by $14 trillion, or 22 percent by the U.S.

Dreaded ‘crexit’ 

With credit ballooning, press reports on the July 20 study latched on to the concept of a Crexit scenario, a systemwide credit correction sparked by more economic shocks in the vein of the U.K.’s surprise Brexit vote in late June.

“A series of major negative surprises … could trigger a confidence crisis and more financial market volatility,” the report said.

“That could easily cause funding conditions to tighten sharply, posing a serious default risk for lower credit-quality companies and challenging the authorities to provide even more monetary policy support.”

But with interest rates as low as they are, the Fed and other central banks may be out of bullets, as the saying goes.

Perhaps a “more orderly credit correction” may set in over the next several years if growth continues at a moderate pace, S&P IQ said.

At the very least, public-equity investors should take a more nuanced view of any interest rate increases. The fear is that they’ll wreck the recovery, but they may actually help increase economic health by curbing an overabundance of leverage.

Action Item: S&P credit report: http://bit.ly/29RSRMu

The Federal Reserve Building is reflected on a car in Washington on September 16, 2008. Photo courtesy Reuters/Jim Young