The Economist July 11th 2020 pp60 Buttonwood “Default Settings” “The corporate bond market has enjoyed a mini-boom. But defaults are on the way”
Information not in the article
Corporate Bond Ratings
AAA
High Credit Quality
Investment Grade
AA
High Credit Quality
Investment Grade
A
Medium Credit Quality
Investment Grade
BBB
Medium Credit Quality
Investment Grade
BB
Low Credit Quality
Speculative Grade Junk
B
Low Credit Quality
Speculative Grade Junk
C
Low Credit Quality
Speculative Grade Junk
Note: These definitions are from Investopedia.com but know that there are many variations by S&P and others who rate the value of bonds.
Summary of Article
“Companies are mercilessly sorted by recessions”. The stronger get stronger and the weaker falter or fail. Thanks to the U.S. Federal Reserve and other central banks buying up corporate bonds many good companies but some “unworthy firms will live on” despite the pandemic and consequently the corporate bond-market has “enjoyed a mini-boom”. This pattern following a recession seemingly repeats itself so in sequence defaults likely will follow.
Companies have enriched their cash position having “issued more than $1trn worth” in corporate bonds. Weaker companies get a lower bond rating but offer higher interest rates in accordance with risk. Some of these bonds are at distressed or "speculative rates" which are 10% greater than government bonds. Low-debt, high credit quality company rates are “closer to those on government bonds”. So while safe their returns leave investors wanting especially in this low interest environment.
With risk comes some failure and “S&P expects that trailing 12-month default rate for junk bonds to rise to 12.5% in America and 8.5% in Europe by March”. Some low credit quality companies may file chapter 11 bankruptcy-to solve their debt problems or others may perform a distressed exchange-if they have cash buy back their own bonds or swap for new ones when they are trading at a lower price. Even before the pandemic certain industries like automakers, oil and gas and retailers were struggling. The pandemic has also changed consumer behavior adding pressure to the at-risk firms plus creating problems for airlines and hotels.
A recovery will happen but some companies won’t make it and investors will struggle to find safe yet good returns in corporate bonds. Companies that survive will look to improve their balance sheet to qualify for a lower cost of credit.