History started repeating itself over the weekend as the leveraged debt market showed signs of crumbling. Moody’s warned that it might downgrade $22 billion worth of collateralized loan obligations (CLO). The ratings agency said that roughly 20% of the CLOs it covers could have their ratings slashed .
In other words: the corporate debt bubble is about to pop and send the U.S. economy into a deep recession.
CLOs are investments made up of hundreds of leveraged loans. Companies with less-than-perfect credit ratings have been turning to Wall Street for funding . Asset managers buy up hundreds of these loans and repackage them into differing tranches depending on their risk level. A highly rated tranche means investors have a better chance of getting their money back in the event of a mass-default.
If that sounds eerily similar to the mortgage-backed securities that brought the U.S. financial system to its knees in 2008, that’s because it is. But proponents of the CLO market are quick to point out key differences that supposedly make these investments more secure.
A frequent argument for the safety of CLOs is that they’re made up of loans from a wide variety of industries. So if one sector is hit particularly hard, those defaults are balanced out by companies in other industries that are still paying off their debt.
Back in 2018, when the bull market started to sputter, some started sounding the alarm over CLOs . Then, fund manager Gene Tannuzzo cautioned on the risk of a mass downgrade.
The risk is that if a bunch of these get downgraded, many CLOs will scramble to sell.
That’s what’s happening right now. More worrying is the fact that nearly half of the bonds to be downgraded have an investment-grade rating. Moody’s isn’t the only one downgrading debt at a dizzying pace. S&P Global Ratings is also reviewing the ratings on bonds for 6.3% of its CLOs.
The Fed has stepped in with unprecedented stimulus— but that may not be enough to avoid a lasting recession. According to UBS, companies without investment-grade ratings can’t tap the Fed’s $10 billion corporate bond-buying program .
According to UBS, the $5.4 trillion non-investment grade debt market could see a default rate of around 10% . That’s a whopping 540 billion in unpaid loans.
This cycle has seen a record share of speculative grade issuance (62% of the non-financial corporate supply), led by loans. In the global pandemic scenario we estimate peak defaults of 10%, 14% and 18% for U.S. high yield, leveraged loans and money market debt.
Then there’s the question of what happens to companies whose debt ratings are on the cusp. The Fed is willing to buy corporate bonds from companies with BBB ratings or higher—but there are a great many in today’s climate that are rated BBB but no longer meet those standards . These companies make up roughly $1 trillion worth of the investment grade-rated bonds on the corporate debt market, according to Scott Minerd of Guggenheim Partners.
BBB-rated corporate bonds, which make up a majority of the investment-grade corporate universe, are also a major concern. Many of these BBB-rated companies don’t pass the criteria to be rated BBB by the rating agencies.
As New York University Economist Nouriel Roubini put it, the Fed is essentially buying junk bonds.
The pandemic has forced the Fed not only to intervene in the market, but the central bank has essentially become the market. That’s dangerous, uncharted territory— especially if you start considering an exit route. Not only is the Fed encouraging risky corporate debt levels, but it’s acting as a backstop for government debt as well.
America’s debt is seen outpacing the economy this year according to calculations by the Committee for a Responsible Federal Budget. While that might sound scary, the government pays less than 1% in interest because it sells Treasury securities to raise money. That makes the debt relatively affordable.
But as Deutsch Bank’s Torsten Slok pointed out, it’s the Fed that’s buying those government bonds . The Fed was buying $75 billion in government bonds daily in March to calm the market amid recession fears. Though that figure has fallen to $30 billion, it still underscores the market’s shocking dependence on the Fed.
Who’s going to buy all these Treasurys? Foreigners? Private investors? It all adds up to supply growing at levels we have never, ever seen before.
And we could be heading into a recession like we’ve never, ever seen before.