US corporate finances improved in the third quarter, according to the Fed’s quarterly financial accounts, holding out hope of some relief from the recent sell-off in corporate credit.
The redemption yield on the Bank of America / Merrill Lynch high yield cash pay index reached 9.1% this week, the highest since 2011, when the yield peaked at 10.1%. The index yield is inflated by distressed pricing of energy bonds but the move higher this year has been general: the non-energy yield has increased from a low of 5.9% in February to 8.3% – see first chart.
A post in June suggested that yields would come under upward pressure following a deterioration in corporate finances in early 2015. The “financing gap” of non-financial corporations – i.e. the difference between their capital spending and retained earnings – was reported by the Fed to have risen to 1.2% of GDP in the first quarter, the highest since the second quarter of 2008. Companies, moreover, had stepped up borrowing to finance share buy-backs and cash M&A transactions. Their total net borrowing requirement – defined as the financing gap plus share purchases net of issuance – had reached 4.3% of GDP. This borrowing measure has been a good leading indicator of yield spreads historically – second chart.
The financing gap, however, fell back to 0.3% of GDP in the third quarter as companies cut capital spending on stocks and non-produced assets. Net share buying last quarter, moreover, was the weakest since the third quarter of 2009. The net borrowing requirement, therefore, declined sharply from 4.1% of GDP in the second quarter to 1.0% in the third.
This reversal may support a near-term stabilisation or recovery in corporate credit but it is doubtful that yields have yet reached a major cyclical peak, for several reasons. First, the current spread of high yield bonds over Treasuries remains well below the levels at previous major highs – second chart.
Secondly, the last three peaks occurred at least a year after the net borrowing requirement topped out. Assuming that the latter reached a maximum in the second quarter, this would suggest mid-2016 as the earliest date for a major yield decline to begin.
Thirdly, the third-quarter improvement in corporate finances may prove temporary. Capital spending on stocks should decline further but earnings and retentions are at risk from rising unit labour cost growth and higher borrowing costs. The third-quarter drop in net share purchases, moreover, is likely to have reversed in the current quarter, with Trim Tabs reporting strong buy-back activity and moderate issuance.
An additional caveat is that the Fed’s statistics are subject to significant revisions and further information could lead to the reported third-quarter improvement being scaled back.
