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Credit Is the Scariest Market to Watch, Not the Dow or S&P

Markets for newly issued company debt and commercial paper have already prompted the Fed to step in.

Credit Is the Scariest Market to Watch, Not the Dow or S&P
A traffic light glows red on a near empty street in Munich, Germany, on March 21, 2020. (Photographer: Michaela Handrek-Rehle/Bloomberg)

(Bloomberg Businessweek) -- While drops in the Dow and S&P dominate the headlines, the market that has many traders and policymakers most on edge right now is debt—that is, bonds and loans. The free-flowing credit conditions that defined the last decade are no more.

Weeks of virus-induced volatility have almost shut down the markets for newly issued company debt, and even short-term IOUs, known as commercial paper, showed enough signs of stress to prompt the Fed to step in. With the usual corporate fundraising outlets closed, companies including Hilton Worldwide, Kraft Heinz, and Caesars Entertainment are tapping credit lines to get fast backup cash.

It’s a stunning‚ and sudden, seize-up in a corner of high finance known for funding megadeals while shrugging off concerns about companies’ ever-growing debt loads. Now there’s no way to know just how bad the coming credit crunch will be. “There’s a real concern for something that was seen as almost impossible in the last few years,” says Scott Macklin, director of leveraged loans at AllianceBernstein. “We could face another credit crisis. Companies need cash more than ever, but the sources are slimmer.”

As the U.S. came out of the last financial crisis, companies took advantage of rock-bottom interest rates and loaded up on debt, helping total business borrowings reach $16.1 trillion, up from $10.2 trillion a decade ago. Investors lined up to lend, in part because U.S. rates, though low, were still much higher than those in Europe and Japan. The ready supply of lenders allowed borrowers to strip investor protections, known as covenants, from risky loan contracts. Even as higher-quality borrowers’ credit ratings slid toward the bottom rungs of investment-grade, the money kept flowing.

Now the companies that borrowed big face a reckoning. Strategists at UBS Group AG estimate as much as $140 billion of investment-grade debt may fall to junk this year, driven by energy companies hit by a global demand slump and the Saudi-Russian oil price war. The strategists expect high-yield bond defaults to soar. “This feels like a very acute, very sharp shock,” says Jim Caron, head of global macro strategies for fixed income at Morgan Stanley Investment Management. He’s not expecting every company that’s increased its debt load to run into trouble, but those with weaker balance sheets will suffer. “Leverage always adds insult to injury,” he says.

In recent days some of the largest, most creditworthy companies, including PepsiCo Inc. and Exxon Mobil Corp., have been able to sell new bonds. But the door remains closed for riskier businesses that might rely on the junk bond or leveraged-loan markets for financing, says Elaine Stokes, a portfolio manager at Loomis Sayles & Co. A prolonged debt market shutdown is a particularly dire threat to the financial system, because the consequences can spread well beyond corporate treasurers’ offices. As borrowing costs for the biggest companies rise, so too can loan interest for smaller businesses and consumers. And failure to get new financing can push a struggling company into bankruptcy, forcing it to cut jobs.

With bigger social costs at stake, many corporate credit investors are expecting more stimulus that could help companies in trouble and grease the debt machine. “We have to get the markets to function normally so that all these companies that we need to be up and running and paying their employees can borrow,” Stokes says.

©2020 Bloomberg L.P.