Investors are happy we have passed through the third quarter of 2015. It was quite a tough time for US companies who showed the weakest performance of the year. Weak global demand and a lack of purchasing power hit these companies hard. The easiest way to increase revenues is to raise prices, but this strategy does not work when consumers don’t have the additional income or the will to pay the higher prices.
We have the issue of the strong US dollar. On Thursday the Europeans announced the next round of quantitative easing and more negative deposit rates. This hit the euro and made the dollar even stronger. The strength of the dollar is hitting US companies that export so many are now reporting declining revenues. This is not just isolated to the energy sector. Of the 142 non-energy companies that have reported Q3 earnings so far, revenues have dropped an average of 3%, when compared to last year, according to Moody’s Credit Markets Review. In a time of declining revenues, companies try to maintain net profits by cutting costs. Moody’s warns that “Results such as these weigh against expecting much of a pick-up by either hiring activity or capital expenditures.” This is an omen of a downward economic cycle.
Even though rates have been historically low for some time now, cheap money is not readily available to riskier borrowers. In Q3 2015, bond issuance by junk rated companies dropped 38% from a year ago. The high yield bond market is sensitive to economic cycles. Commonly referred to as junk bonds, these debt securities are issued by companies with lower quality credit ratings. Because of the increased risk, they must offer higher interest rates than their lower risk peers. When spreads widen between junk and stronger credit issuers, it costs junk companies more to borrow.
Morgan Stanley reports the US junk bond market has experienced its weakest four month stretch, from June-September 2015, since the end of 2008. This return of -7.03% was a factor of weaker energy prices, decrease in commodity values, uncertainty of Fed rate increases, and a weakening overall global economy. During this time, bond issuance by junk-rated companies and leveraged loans plunged 37% from the prior year. For the 12 month period, total issuance is down 29% from the 12 month all-time record in 2013. This phenomenon is also worldwide as high-yield corporate bonds are down 30%. Oil and gas companies have plummeted their issuance by 83% and other companies have dropped 21.5%.
Yield spreads between junk bonds and treasuries have widened to 700 bps. Now the past three recessions have started within eight months of the yield spread in junk bonds exceeding 700 bps and also within 15 months of a top in the junk bond market. In 1989, the spread rose above the 700 bps level just eight months before the recession of ’90-’91. In 2001, the gap hit just five months before the 2001 recession. In 2008, the bond market had already topped and the yield gap hit one month after the financial meltdown occurred.
The next troubling sign is a drop in the overall credit ratings. High-grade borrowers have access to funds in difficult times, but the number of high grade borrowers is shrinking. Companies have also mussed up their balance sheets for more M&A activity and also share repurchases. Downgrades have pushed many of these companies into medium grade issuers. From 1995 to 2012, bond issuance by high-grade companies was nearly double the issuance by medium grades. But not anymore. Since 2012, medium-grade offerings have outpaced higher grades by 24% annually. In the past quarter, medium-grade issuance soared to 47% higher than the safest rated companies. Many of these companies have been downgraded since they issued these bonds a few years ago. If their ratings stay where they are now, if they have to refinance their bonds, they will be refinanced with lower-rated, more expensive debt.
Moody’s sums up that the deterioration of credit indicates that companies are losing financial flexibility. Lower rated borrowers are experiencing higher credit costs and access to credit is becoming difficult or even impossible. Corporate outlays on staff and capital goods may be curbed more rapidly in response to a weaker business outlook. In the past month, companies such as Wal Mart, Caterpillar, Target, and Hewlett-Packard have all announced cutbacks. This trend has moved way beyond the energy sector.
On the credit side, risks are building in the banking sector. The Comptroller of the Currency recently quoted, “Reminds me of what happened in the mortgage backed securities in the run up to the crisis.”