Earlier this week, in the course of summarizing the main points from the latest missive by SocGen’s incorrigible (yet exceedingly affable) bear, Albert Edwards, I mentioned that my own view of the Fed’s foray into corporate bond purchases is relatively sanguine.
It’s not that I don’t appreciate the moral hazard critique. Rather, it’s that the genie left the bottle some years ago.
When the Fed cut rates to zero and embarked on what, in the pre-COVID world, counted as “large-scale” asset purchases, the effect was to push investors out the risk curve and down the quality ladder. One explicit goal was to lower corporate borrowing costs.
Read more: Albert Edwards Predicts Zombie Apocalypse
This hunt for yield intensified as time went on, creating voracious appetite for anything that offered any semblance of yield in a world were the global stock of negative-yielding debt eventually topped $17 trillion (figure below).
In Europe, things became so surreal that entire corporate curves went negative at one point last year. Those companies could effectively mint “assets”.
Of course, outright purchases of corporate bonds have been going on in other locales for some time, and the ECB’s presence in the market is one reason why the € debt market long ago became a funhouse mirror.
The point is that in a world where capital can go where it pleases, and central banks are engaged in competitive easing (a “race to the bottom”, as it were) there will be a perpetual bid for anything that offers yield pickup. Corporate borrowers in the US benefited from this, as evidenced by persistently low yields and rising leverage across virtually the entire post-financial crisis era.
Indeed, “zombie” companies (whose debt servicing costs exceeds profits) in the US and Europe have been on the rise for a decade. There is nothing uniquely “COVID” about the notion of central banks buying corporate bonds and otherwise facilitating “zombie” dynamics.
The deluge of borrowing from panicked corporates in the first half of 2020 means it is highly likely that the percentage of companies counted among the “undead” will rise going forward, especially in the event the recovery proves to be less robust than optimists anticipate.
In the US, investment grade and high yield issuance during the second quarter broke records. That borrowing was enabled by the Fed’s backstop, despite the fact that Jerome Powell didn’t buy any corporate debt until early May (ETFs) and purchased no individual corporate bonds until last month.
The red bars in the figure (below) give you some context for the deluge of blue-chip debt issuance witnessed from March through June.
So, while the problem is likely to worsen, let’s not pretend like a dozen years of easy monetary policy (turbocharged in the US in late 2017 with the Trump tax cuts) hasn’t amounted to a giant, rolling corporate bailout.
I suppose you could argue that in the period between 2009 and 2019 (i.e., between the GFC and the pandemic) “bonanza” is a better word than “bailout”. Credit market stress has been subdued in the post-GFC world, so it’s been a windfall more than a godsend. But that begs the question. That is, of course market conditions have been benign. The Fed and its counterparts across the globe have deliberately prolonged the cycle, compressed spreads, suppressed default rates, and stamped out price discovery. So who’s to say whether it’s a “bailout” or a “bonanza” — a helping hand or an unnecessary handout? We don’t know, because in a world characterized by an increasingly desperate hunt for yield, virtually anybody can borrow.
“Capitalism was lost long before COVID-19”, Deutsche Bank’s Jim Reid writes, describing the following visual, which encapsulates many of the points made above and puts the pandemic response in a historical context.
What I would gently (and quickly) note is that capitalism may be “lost” in the sense that policymakers have no appetite for creative destruction, but it’s certainly still working its “magic” when it comes to perpetuating inequality of all sorts, ironically helped along by loose monetary policy.
In any event, you could argue that the borrowing associated with the pandemic is infinitely easier to forgive (figuratively and, perhaps, literally) considering it wasn’t motivated by a desire to, for example, fund share buybacks with debt, but rather by survival concerns.
Suppressing default rates from here will presumably require an even more concerted effort to keep real yields low.
As Harley Bassman likes to say, “there are only two avenues out of a debt crisis – default or inflate, and inflation is simply a slow-motion default”.
There is another avenue — namely, blockbuster growth. But as Bassman wrote last month, “I think COVID-19 has closed off that possibility”.