Raw Finance

As defaults rise on non-investment grade corporate bonds, also referred to as “high-yield” or sometimes “junk” bonds, otherwise healthy organizations must offer higher rates of interest on their investment grade debt to continue to attract investors.  Bonds are an alternative to shares of stock for companies to raise capital.  Usually bonds are issued by companies to finance expensive projects that they expect to enhance their business in the future.  Thus, bond issuances are a way of borrowing money from private investors.

According to Moody’s Investor Service, currently, high yield bond spreads anticipate a default rate of 21% in the U.S.  Specifically, record bond spreads are not only due to firesales but find some justification in the deterioration of credit quality down the rating scale.  Similarly, the spike in the projected default rate is in line with the deterioration of credit quality of outstanding debt down the rating scale.

In light of that news, the cost of protecting debt from default rose to an all-time high in Europe and neared a high in the U.S.  The avenue of protecting debt from default is something we have discussed before in a different area, credit default swaps (CDSs). A market for CDSs exists for all types of debt, not just mortgage-backed securities (MBSs).  What made the CDS market for MBSs notable was the fact that it practically disappeared overnight when the housing downturn began, leaving many investors with worthless CDSs and no protection on the securities they held.

CDSs pay the buyer face value in exchange for the underlying securities or the cash equivalent should borrowers fail to adhere to their debt agreements.  An increase in the price of a CDS indicates deterioration in the perception of credit quality; a decline signals the opposite.  A basis point on a CDS contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.  Earlier today, a European market index for 125 investment-grade companies (Market iTraxx Europe), rose 10 basis points.

As the higher cost of borrowing continues to spread through the economy even to rock-solid companies, all corporations will need to consider cutting costs and/or delaying projects, putting a further damper on the economy.