Navigating the Waters of Corporate Debt: A Guide for the Rest of Us
The Wave of Corporate Debt Defaults: Should We Be Concerned?
In recent times, the buzz around corporate debt and rising interest rates has been hard to ignore, especially for those of us keeping a keen eye on our retirement funds, like 401k plans and rollover IRAs. The thought of a shaking economy and its impact on our hard-earned investments can be unsettling, to say the least. However, let's take a step back, breathe, and look at the broader picture together, in a way that's easy to understand and, hopefully, a bit reassuring.
The Wave of Corporate Debt Defaults: Should We Be Concerned?
The last couple of years have seen a notable uptick in corporate debt defaults, with numbers climbing from 85 in 2022 to 153 in 2023, and by early 2024, we've already witnessed 29 defaults. These figures might seem daunting at first glance, suggesting that many companies are finding it challenging to manage their debts amidst rising interest rates.1 Yet, there's more to this story than meets the eye.
Understanding the Current: The Real Health of Corporate Finances
When experts assess the financial health of corporations, they often turn to credit markets. This is akin to checking the temperature before deciding if it's a good day for sailing. The key question they ask is: how much does it cost for companies to refinance their debts? Despite the rise in defaults, the cost for companies, especially those not rated top-notch, to refinance their bonds is surprisingly lower than it has been since mid-2022.
This brings us a silver lining. The cost of borrowing, despite all the turmoil, is actually more manageable for companies than you might expect. Even those issuing higher-risk "junk" bonds are seeing significantly lower added costs to their interest payments compared to just a couple of years ago.
The Tide of Credit Spreads: What They Tell Us
Credit spreads—essentially the difference in yield between corporate bonds and safer government securities—offer clues about the risk of corporate debt. Recently, these spreads have been narrowing, suggesting an optimistic outlook from the market. This is similar to seeing smoother waters ahead despite current choppy conditions. It indicates that, on average, the market sees a positive environment for corporate borrowing and economic growth.
The left circle highlights when the Markets adjusted to Higher Interest Rates and Tighter Fed Monetary Policy (“Quantitative Tightening” or “QT”). The right circle denotes when Silicon Valley Bank and other Regional Banks failed due to the higher rates and QT causing a lack of liquidity and demand depositors made runs on the banks.2 Note how both lines are sloping downward and to the right. This trend indicates even High-Yield (sometimes read, “Junk Bonds”) spreads are narrowing relative to investment-grade yields, and also that Investment-Grade Yields (Baa and above) continue to narrow slightly above the “risk-free” 10-Year US Treasury Constant Maturity. It is axiomatic that falling yields translates to rising bond prices.3
Deciphering the Rise in Defaults Amidst Positive Signs
The recent increase in defaults might seem contradictory to the positive signals from credit markets. However, these defaults reflect past struggles—think of them as echoes from a storm that has passed. They highlight the impact of past economic challenges and interest rate hikes on some companies. Meanwhile, the optimistic credit spreads are like a lighthouse, guiding us towards what lies ahead: potentially smoother sailing as companies continue to navigate through the economic waters.
For Us, The Investors
There's a growing anticipation of interest rate cuts, which could ease borrowing costs and encourage a more robust investment climate. This optimism has prompted many investors to lean towards a more positive stance on corporate bonds, with companies responding by issuing more debt. This is a good sign, indicating a strong and resilient corporate America, buoyed by healthy investments and solid financial foundations.
As 2024 progresses, we might hear about more defaults, which could stir up some concern. However, it's important to remember that as long as borrowing costs remain relatively low and the economy shows signs of strength, these defaults represent the challenges of yesterday, not necessarily a forecast of tomorrow.
The Takeaway
For those of us watching our retirement funds and worrying about our financial futures, the landscape of corporate debt and interest rates certainly deserves attention. But it's also crucial to see the full picture and recognize the resilience and potential for growth that lie ahead. So, let's stay informed, keep our sails adjusted, and remember that navigating through financial waters, though daunting at times, can lead us to calm seas and sunny horizons.