Ok, dammit.
It’s been clear for years that excessive and prolonged central bank accommodation has paradoxically served to create a disinflationary impulse in some sectors of the economy.
Nowhere is this more readily apparent than in the US energy complex. Otherwise insolvent production was allowed to effectively hibernate – as opposed to going out of business – during the downturn in oil prices thanks to wide open capital markets.
With investors starving for any semblance of yield, markets remained open to companies that would, under normal circumstances, have lost access. Poor balance sheet discipline was rewarded rather than punished and far from being purged, misallocated capital became even more misallocated in a kind of reverse-Schumpeter dynamic that reemerged with a vengeance following the OPEC cuts late last year.
Investors and Wall Street threw money at US operators during H1 and indeed, the bonanza recently reached such a fever pitch that Anadarko boss Al Walker characterized his own industry as a gang of out-of-control alcoholics that need an intervention if they’re to be weaned off the easy money morphine drip.
In June, supply finally dried up, but it wasn’t obvious whether that was attributable to widening spreads, or whether it was simply a byproduct of producers not needing to refinance:
(Goldman)
Even when you consider that the recent move lower in crude was accompanied by higher HY Energy spreads, the bond market still isn’t sending a strong enough message.
“We believe this may not send a requisite message to rein in drilling activity for all producers,” Goldman wrote, in a note out earlier this month, adding that “on the flip side, it sends a theoretical message for producers to issue more debt.”
Of course this raises significant questions about the viability of these firms in a rising rates environment – especially if oil prices can’t manage to sustain a meaningful bounce.
Panning out, leveraging the balance sheet to take advantage of wide open capital markets is a phenomenon that is by no means isolated to the energy space. Corporates of all stripes (so, including IG), have financial-engineered their way to better bottom lines by buying back shares with money borrowed at artificially suppressed rates.
This may or may not be sustainable again, depending on where we actually are in the cycle and where rates go from here. Indeed, as the IMF recently noted, the ability for HY issuers to service their debt has become completely disconnected from the way the market is appraising that same debt. Have a look:
All of this is to a large extent a product of central bank policy and it doesn’t take a leap of logic to figure out that in Europe, the dynamic might be even more pronounced given the fact that the ECB actually buys corporate bonds.
More than a few commentators (and we’re included in that group) have characterized US energy operators living on borrowed time as “zombie companies.” Recall this from Citi’s Matt King, for instance:
Well on Monday, BofAML’s Barnaby Martin is applying that same label to some European corporates. Read below as Martin expounds on everything said above in the context of the ECB’s CSPP…
Via BofAML
The rise of the “Zombies”
Draghi was surprisingly dovish last week, pushing back at length against his recent Sintra hawkishness. Inflation remains uncomfortably low for the central bank. Credit markets liked what they heard, with CDS spreads grinding tighter on Friday. In our view, more of the same from Draghi bodes well for a continuation of the super strong inflows that are characterizing Euro credit at present.
Yet, ECB QE tapering is probably the worst kept secret in markets. Not only is the programme hamstrung by its own technical constraints, but politicians across Europe have been angling for less of it, for fear that it has been stoking wealth inequality. By the end of next year, we think QE will be no more.
This still leaves a lot of time for ECB corporate bond buying to remain though. And as the programme rolls on, issuance continues to be plentiful. This year, however, we believe that the story in debt markets has not been “financing for all”. In fact, we find that bond issuance has been concentrated in the hands of the few, rather than the hands of the many. The result has been that “superfirms” have been quietly building across the credit market.
With debt creation brisk in Europe, how vulnerable does this leave the corporate sector to a future period when ECB support is no more and rates are higher? Although corporate leverage has helpfully declined over the last few years, we still find a collection of companies with very weak interest coverage metrics in Europe (“zombie” companies). And while there has been a notable decline in zombies in Europe over the last year — thanks to a profit revival and ECB QE — there are more zombie companies today than pre-Lehman times, and more zombies in Europe than the US at present. Financial vulnerabilities still lurk in the European corporate sector, therefore.
We think this supports the point that our economists have been making: that the ECB will likely be very slow and patient in removing their extraordinary stimulus over the next year and a half.
“Superfirms” emerging in credit
CSPP has been a defining moment in the short history of the Euro credit market. The perception has been that it has facilitated debt market access “for all”. Certainly issuance has boomed over the last 16m, and there has been a steady stream of new names coming to the market. But we think the narrative is less obvious than this.
In fact, this year, we find that bond supply has been much more concentrated in the hands of the few, rather than the hands of the many. To highlight this point, consider the following statistics:
- In both 2013 and 2014, roughly 250 different companies tapped the Euro highgrade market for funding,
- In both 2015 and 2016, this number jumped to roughly 300, clearly spurred-on by the ECB’s QE efforts,
- But this year, there has been a notable drop-off in the breadth of credit market supply. So far, only 180 different companies have issued Euro debt.
That’s not to say that credit market appetite has dried up, far from it. This year, however, it’s clear that mega financings have proliferated. Chart 1 shows how the issue sizes of Euro IG supply have grown. CSPP has clearly been a big catalyst. Easy credit conditions have helped “superfirms” emerge across the credit market:
- Note that in both 2015 and 2016, the top 20 bond issuers in those years accounted for around a quarter of total supply,
- But in 2017, the top 20 issuers have accounted for almost 40% of supply.
Chart 2 emphasizes this point. We show the average size of high-grade debt outstanding for the top 10 companies in the Euro credit market, over time. Note how the average amount of debt for the top 10 companies has jumped (from €17bn to over €20bn) since the start of last year.
The rise of the “Zombies”
As strong credit issuance continues in Europe, and “superfirms” emerge, how vulnerable does this leave the corporate sector to a future period when ECB support is no longer here, and rates are higher?
The good news, as we have flagged in previous research this year, is that average corporate leverage has declined to low levels in Europe, as firms’ cash generation has been impressive. Yet, we still find that there is a group of companies in Europe with very weak interest coverage metrics — especially in smaller firms and the periphery — that would struggle under higher rates. Financial vulnerabilities in the corporate sector therefore remain.
Below, we draw on the recent work of the BIS/IMF (and OECD) to track the existence of “zombie” companies in Europe. “Zombie” companies are those defined with interest coverage ratios (EBIT/interest expense) sub 1x. The metric identifies companies that can’t (or can barely) cover their debt costs out of current earnings, and thus may be the most vulnerable as interest rates rise.
In the charts below, we highlight the percentage of companies in the Euro Stoxx 600 (and for comparison the S&P 500) where interest coverage is 1x or less. We use quarterly Bloomberg data on interest coverage, and focus only on the non-financial firms.
A big helping hand from the ECB…
Chart 5 shows that currently, 9% of non-financial companies in Europe (by market cap of Stoxx 600) are zombies, with interest coverage ratios at or below 1x. Note that this is still quite a high number: it was around 6% pre-Lehman, and fell to 5% in late 2013 after the peripheral crisis had faded.
The plethora of monetary support in Europe over the last 5yrs has allowed companies with weak profitability to continue to refinance their debt and stave off defaults.
The good news, though, is that there are fewer zombies in Europe now compared to a year ago (in June 2016 it was 11%). Two things are likely to have driven this big decline. Firstly, a tangible earnings recovery after years of stagnant profit growth in Europe. Secondly, ECB QE (including corporate bond buying), which has reduced corporate debt costs for those that have refinanced.
For comparison, chart 6 tracks “zombies” in the US market. At present, there are slightly fewer zombie companies in the S&P 500, around 8% by market cap (which we think is also a function of the very high market cap of FANG stocks etc). However, the current reading is close to a record, and has doubled since the end of 2014.
Part of this reflects oil price volatility, which has weakened the fundamentals of energy and utility firms. But it also likely reflects the willingness of US issuers to releverage balance sheets over the last few years.
And of course, as tipped above in our own analysis, any rates tantrum would only make things worse.
Or, as BofAML concludes, “allowing a bund shock and a credit tantrum to take hold would only pressure corporate interest costs again, and risk a rise of the zombies”…
