A decade of easy money sloshing around the economy may come to haunt policymakers as legions of firms hooked on cheap credit have no buffers to make it through the coronavirus crisis without serious damage, or outright failure.
Amid signs that banks and investors have already retrenched their lending, central banks are trying to ensure that the flow of credit to businesses remains open.
But those loans, however soft, will still have to be paid back, and therein lies the rub as many won’t be able to generate the necessary revenue.
The volume of corporate debt struck an all-time real term dollar high of $13.5 trillion at the end of last year, according to the OECD.
Including bank borrowings, “the global (corporate) debt-to-GDP ratio … is near a record high of 94% and is at, or near, all-time highs in many major economies,” Capital Economics noted in a recent report.
This has created a growing number of so-called “zombie firms” – companies who just about manage to pay interest on their loans with ongoing credit deals, but have no prospect of settling up on the principal.
A 2018 report by the Bank of International Settlements put “zombie firms” at between 6 and 12% of total companies and said that ample cheap credit was partly to blame.
Even if that number seems small, it can quickly turn into a major risk.
Journey to junk?
Capital Economics said it had identified a “BBB bulge” in the US and eurozone corporate bond markets comprising just over half of all new investment grade bonds over the past three years.
BBB is the lowest investment-grade rating. When firms drop below this into “junk” territory they face higher borrowing costs as many investment funds are limited to buying only investment-grade bonds.
A virus-induced recession or a surge in borrowing costs, or both, could trigger bond ratings agencies downgrade many of these bonds into junk status.
“The greater the virus-related disruption, the closer we will get to this tipping-point” with the virus acting as a “trigger”, warned Capital Economics.
The OECD estimates that if a financial shock arrived comparable to 2008 then $500 billion worth of corporate debt would migrate to junk-rated levels inside 12 months.
‘Zombies’ and other struggling firms would then come under intense pressure to lower their debt through job cuts and salary freezes, as well as cutbacks on investment.
But “this then hits demand, which in turn prolongs downturns which weighs on profitability, making further deleveraging more likely” in what becomes a vicious circle, said Capital Economics.
Such an impact on the wider economy is what economists call second-round shocks and can cause a longer and deeper crisis than the original upheaval.
“We are at the eye of the storm,” said Vincent Marioni, European director for investments in Europe with Allianz global investment management firm.
Central banks to the rescue
“The important thing over the coming two months is to maintain the liquidity of firms and ensure that a liquidity crisis does not morph into an insolvency crisis,” says Florence Barjou, head of multi-asset investment with Lyxor AM.
While central banks including the US Federal Reserve have lowered interest rates, they have also undertaken steps to ensure the credit taps remain open.
The European Central Bank unveiled a number of such so-called targeted measures after its meeting on Thursday.
In particular it lowered the rate on funds it makes available to banks to pass onto companies, and in certain cases it will be paying banks to lend on the funds.
The ECB, which supervises large eurozone banks, also said it would allow them to temporarily lower capital buffers and use additional types of assets.
“Banks will see a weakening of their loan book quality as the effects of the virus will reduce global travel and factory output, and dampen domestic demand in Europe,” said Bernhard Held, VP senior credit officer for Moody’s Investors Service.
“The outbreak adds to late-cycle risks associated with weakening economic prospects across the region as reflected in our negative outlook for the European banks.”
Allianz’s Marioni noted that in the United States a large chunk of corporate debt is directly linked to the oil sector.
Given that the gyrations in crude prices have caused a bumpy ride for oil firms over recent months “the (current) fall in the price of oil will really complicate matters for them,” he forecast.