Financial Conditions Ease for Junk-Rated Companies as Easy Money Era Draws to a Close
Financial conditions are loosening once again for junk-rated companies, signaling a potential end to the era of easy money. Despite the Federal Reserve’s efforts to tighten financial conditions by raising interest rates, these companies continue to face challenges in generating enough cash flow to cover their interest payments.
The spread between junk-rated debt and risk-free debt, such as Treasuries, is one measure of tightening financial conditions. Currently, the average spread for BB-rated bonds, the upper end of the junk bond spectrum, is just 2.66 percentage points. This spread has narrowed from 4.1 percentage points in July 2022 and reflects the ongoing pursuit of yield by investors.
However, despite these tightening measures, financial conditions remain relatively loose by historical standards. This excess liquidity has allowed over-indebted junk-rated companies to borrow new money to pay interest on existing debts, keeping them afloat. But as financial conditions continue to tighten, many of these companies may find themselves in a precarious position.
Bankruptcy filings among larger corporations have already reached their highest level since 2010, with 340 filings in the first half of the year. Although this represents a 20% increase from pre-pandemic levels in 2019, it is a modest rise considering the recent rapid tightening of financial conditions.
In previous economic downturns, such as the 2008 Financial Crisis, bankruptcy filings widened significantly. However, the relatively low increase in bankruptcies during the current tightening phase suggests that investors are still willing to take on risks without adequate compensation.
The Federal Reserve’s actions during the pandemic, including buying corporate bonds and lowering policy rates, injected trillions of dollars into the economy, further exacerbating the liquidity-driven environment. Now, with interest rates over 5% and quantitative tightening underway, the easy money era is coming to an end.
While bankruptcy filings have been influenced by factors such as mismanagement, structural changes in the economy, and competition, the tightening of financial conditions serves as a necessary wake-up call. It emphasizes the need for better financial discipline and cost controls to ensure a more sustainable and resilient economic future.
Overall, as financial conditions gradually tighten, over-indebted junk-rated companies will face increasing pressure to restructure their debts, potentially at the expense of stakeholders. While bankruptcy filings have not spiked significantly, the slow process of tightening suggests that the full impact of these financial conditions may still be unfolding.
