It has been a busy few weeks in the corporate bond markets. Companies are taking advantage of seemingly ubiquitous cheap money, while at the same time lightening the covenants attached to that money. Investors have formed orderly queues to lend and have - perhaps surprisingly - acquiesced in these reductions in their protections. Meanwhile, central bankers are carping from the side-lines, warning anyone who wants to listen of the dangers of this (and other) lending. This is somewhat ironic, considering that their quantitative easing programmes were designed, in part, to tempt individuals and institutions up the very risk curves that they are warning us about.
And so in the last week in July, multi-national telecoms conglomerate, AT&T launched the third largest bond sale on record in order to complete the financing of its $85bn acquisition of Time Warner. The company was looking to raise just over $22bn at various maturities. The issue was priced keenly relative to the company’s existing debt with the ten year tranche pricing at 1.6% above the risk- free US Treasury rate. Yet there was a long queue to participate at these prices, with the issue being three times oversubscribed.
Record levels of corporate debt
This issue continued a fairly frenetic period in bond markets. Dealogic estimates that more than $1trn of corporate debt has been issued in the US this year, matching the fastest pace on record. Perhaps worryingly, this is a pace not seen since the heady days of 2007. AT&T has been the largest issuer, but others including Microsoft and Broadcom have produced multibillion dollar offerings. Pricing is similarly enthusiastic: spreads relative to the risk-free rate are at their lowest levels for a decade, but with the risk-free rate half what it was a decade ago. Cheap money indeed, for those who can get it.
Financial corporate bonds that have been the leading performers in the credit market, in particular subordinated insurance bonds. This is proof, if any were needed, that investors believe those corporate bonds that were at the epicentre of the financial crisis are not only out of intensive care, but are leaving the general ward and hailing a taxi home.
A covenant-lite environment
And at the same time, albeit in sometimes slightly different markets, investors appear happy to reduce or forego the protections that have normally been required when lending to slightly riskier borrowers. These protections, or covenants, give investors a level of security should company performance not match initial expectations. Covenants are obviously worth something – thus investors are taking the view that even without them, the risk and return equation still stacks up. It’s a growing body of opinion: S&P estimates that in the US leveraged loan markets, more than 70% of issues can now be defined as “covenant-lite”.
We have heard increasingly anxious musings from the Central Bank fraternity about the actions both of lenders and borrowers. Both the Federal Reserve and the Bank of England have warned of growing risks appearing in the auto loan markets. Separately, the Bank of England’s Financial Policy Committee has accelerated its assessment of the UK banks’ exposure to consumer credit – a reaction to its nervousness that lending standards had weakened. And in a global context, the Bank of International Settlements has also urged caution, given the extent of recent lending by the financial sector. As I noted above, it is arguably the policies of these very central banks that are the cause of the concerns that they note. Nevertheless, their warnings should not be ignored.
A time to be careful
But of course, and on a more positive note, ten years on from 2007, the global financial system is thankfully in much better shape than it was – regulatory, management action and time has been a great healer. And while one might be nervous about the prospects for higher interest rates, there are good reasons why these rates need not return quite from when they came. In the end, investors have lent to credits they feel comfortable with, issued by companies operating in a global economy that is behaving relatively well. Hence there may be more value in some of the current debt offerings than some of the more sceptical (and generally older) observers would argue.
However, it feels like a time to be careful. It feels like a time to be sure about what you are buying and be confident in the protections that come with your loan (or if none, that you have been paid to forfeit them). It feels like a time to make sure that your investments can survive the bumps in the road that we can see – and, more importantly, the ones that we cannot.