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Trading  | February 5, 2018

Stocks aren’t the only losers from the recent spike in yields: according to a new note out of Standard & Poors, record corporate leverage and rising interest rates could lead to a potentially explosive cocktail, one in which the removal of the “easy money punch bowl” could trigger a wave of corporate defaults.

The combination of easy liquidity coupled with lax underwriting standards, a yield-starved buyside, record number of covenant-lite deals and low interest rates have contributed to a spike in the number of highly leveraged firms, creating a risk “masked” by relatively low default rates, Bloomberg writes. As Goldman first pointed out last summer, even as corporate defaults remain near historically low levels, froth “has been building in the form of corporate leverage. While this may not present a near-term risk, the widespread increase in debt resulting in stretched leverage metrics bears watching, in our opinion.”

Fast forward to today when S&P analysts caution that “despite a recent rise in corporate profits and financial metrics, the still high leverage of global corporates poses a significant credit risk.”

Using a global sample of 13,000 entities, the rating agency estimated that the proportion of highly leveraged corporates – those whose debt-to-earnings exceed 5x – stood at 37% in 2017, compared to 32% in 2007 before the global financial crisis.

Furthermore, over 2011-2017, global non-financial corporate debt grew by 15 percentage points to 96 percent of GDP.

“On average, corporates are at the top of the credit cycle. Lower asset prices and liquidity reversals are major risks,” S&P wrote.

And the punchline: “Removing the easy money punch bowl could trigger the next default cycle since high corporate debt levels have increased the sensitivity of borrowers to elevated financing costs.”

S&P then warns that the extraordinary post-crisis monetary stimulus created a gap between default rates, which remain low, and the number of highly leveraged corporates, which has surged as firms took advantage of easy liquidity.  This “masked” discrepancy between leverage and defaults is so wide that the recent pick-up in corporate earnings and financial metrics – especially thanks to tax reforms in the U.S. – “won’t be enough to offset” the significant credit risks, S&P said.

“When debt is this steep and default rates are low, something’s gotta give,” wrote the firm’s Terry Chan. “A material repricing in bond markets or faster-than-expected normalization in money market rates could impact credit profiles.”

Terry is, of course, correct; the question is when does this repricing hit. The answer would be revealed in move of junk bond yields, and potentially market prices of tracking ETFs. Apropos, as Jeff Gundlach pointed out on Friday, the charts of the HY ETFs JNK and HYG – which are most sensitive to liquidity conditions for the most levered corporations – “look like death.”

Should the recent selling in JNK and HYG continue, the tipping point which could result in defaults for over a third of the S&P universe of 13,000 companies may not be too far away.

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