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The next default crisis is taking root in the junk-bond and leveraged-loan markets, according to analysts at the S&P Global credit ratings service.
As risk rises, interest rates typically do also to compensate investors for the greater chance of losing their money, the analysts note, but “just the opposite is now true,” they wrote in a research report.
As an example, Coinbase, rated as a high-risk loan prospect, has just secured a 10-year bond carrying an interest rate of 3.625 percent, within half a percentage point of what the U.S. government paid to borrow in 2018, the analysts noted.
From 1 January through August this year, the combined value of planned and completed mergers and acquisitions worldwide totaled a record $3.6 trillion, with half in the U.S., as we reported in “M&A Spree Continues as the Bigs Get Bigger, Rich Get Richer” (14 Sep 2021).
Avenue Capital Management, a private equity firm, has turned down “hundreds of deals” recently, CEO Marc Lasry told a conference last week, because of concerns that borrowers would have trouble making payments in years to come, according to the Financial Times.
“There are a lot of knuckleheads out there and a lot of people making huge mistakes,” he said, making risky bets for fear of losing out on deals that others seem eager to fund.
U.S. financial conditions are as loose, and loans are as easy to get, than at any time since at least 1982, according to a Goldman Sachs analysis cited by the FT.
The current lack of broader investor safeguards likely will persuade private equity companies to pay themselves lavish dividends when they take over companies of questionable worth or by using high leverage, analysts at Moody’s warned.
This year has already seen a record number of leveraged buyouts, surpassing the previous record set when the economy collapsed in 2007, data firm Refinitiv noted.
In 2020 and 2021, 8.4 percent of high-leverage private equity deals defaulted on loans, compared to just 5.2 percent of heavily indebted companies that lacked private equity involvement, Moody’s found.
Lenders are lured into these outlandishly risky deals because they are “aggressive and highly optimistic,” according to a research paper by economists at New York and Stanford universities.
“Investors appear to be making a bet that is highly asymmetric to the downside,” the paper noted.
During the Great Recession, Wall Street banks were left holding a bag of failing loans. During the current crisis, asset managers have made the loans on behalf of pension funds, endowments, and individuals, the FT pointed out.
“We’ve learned…not all bets pay off,” the FT said.
TREND FORECAST: We repeat what we said in “Risky Companies Snapping Up Cheap Loans” (23 Feb 2021): the junk bond and leveraged loan markets are gamblers’ games and many of their bets will come up craps when interest rates rise, as they will next year (see related story).
We said in “Bond Market Tightens, Junk Bonds in Crisis” (24 Mar 2020) that the “Greatest Depression” will trigger a wave of defaults larger than that of the Great Recession. Bottom-of-the-barrel junk bonds, those rated B3 or lower, made up 38 percent of the junk bond market in July 2019, compared with 22 percent in 2008, according to Moody’s Analytics.
After another year of cheap money, market euphoria, and $250 billion in SPAC speculation, the problem has become enormously worse.
“Investors probably will be surprised at the extent of their losses,” said Oleg Melentyev, a Bank of America investment strategist, in spring 2020. He estimated 29 percent of junk loans will fail when credit tightens again, as the Fed is preparing to do next year, compared to about 20 percent during the Great Recession; and that investors will recover only about 50 cents on the dollar against 58 cents in 2007 through 2009.
They will be lucky to collect even their 50 cents now.