COVID-19 has created a surge of riskier, lower rated corporate bond offerings to investors. But debt overhang is a looming concern.
COVID-19 is significantly affecting the capital market landscape – with more risky corporate bonds, those rated BBB and lower, dominating new issuance in the capital market.
“What we found is that since the COVID-19 crisis, firms have issued more, significantly more, corporate bonds compared to the months prior to the crisis, and compared to the three previous years,” says Monash Business School Associate Professor Jin Yu.
“The surge in bond credit activities is higher across the board, including high rated and low rated bonds such as BBB rated which is just one level higher than junk bonds, which is of some concern. Bonds are also tending to be issued with longer maturity dates over this period.”
A rise in BBB bonds
In 2019, only around three BBB rated bonds were issued per week between the months of January to May. In comparison, during 2020 over the same period, there an average of 13 BBB rated bonds were issued per week – with some weeks even recording up to 21 new BBB bonds.
In a paper, co-authored with Associate Professor Michael Halling from the Stockholm School of Economics and Professor Josef Zechner from the Vienna University of Economics and Business, Associate Professor Yu from Monash Business School’s Department of Banking and Finance, explores how public capital market activity is impacted by the Covid-19 pandemic.
The paper, published in The Review of Corporate Finance Studies, investigates the primary capital market in bonds and new equity issuance for United States firms during the period from 16 March 2020 (the beginning of the COVID-19 crisis) to 15 May 2020.
The team also investigated the spread or borrowing cost of the bonds, that is the interest rate above government bond interest rates and found that during the COVID-19 period, firms were paying higher spread with those with a high proportion of fixed assets being charged more.
“Generally, firms with a high proportion of fixed assets (property, plant, and equipment) would pay a lower level of interest,” says Associate Professor Yu.
“But during the crisis, this relationship was reversed with firms with higher proportions of fixed assets paying more interest.”
Inflexible fixed assets harder to sell
Associate Professor Yu, explains that this is because, in good times, fixed assets can be used as collateral. But in bad times, they are a liability as fixed assets are harder to sell, particularly so during the pandemic when everyone else faces the very same difficulties
“What this means is that firms in the industries of transportation, hotels, restaurants etc are not only affected by the lockdown as again it is harder for these industries to generate revenue by simply asking their employees to work from home, they are also having to pay increased levels of interest,” he says.
Unlike the bond market that has been fairly popular during the crisis, there has been a lull in new equity issuance.
Capital raised during COVID-19 via equity issues is approximately only five per cent of the capital raised via bond issues.
“Issuing equity is costlier than issuing bonds. Equity is subjected to an information problem which is exacerbated in times of crisis. There is also evidence from previous studies that firms tend to release less information to the market in bad times,” Associate Professor Yu says.
“In March stock indices have fallen dramatically. Significantly fewer firms were willing to issue equity during these periods as they believe the price will be below fair value.”
US bond market programs
Another major factor driving growth in the United States bond markets has been the Federal Reserve’s Primary Market Corporate Credit Facility Program and the Secondary Market Corporate Credit Facility. Under this program, announced on March 23, the Federal Reserve is buying debt issued by good quality firms – those rated investment grade.
However, a consequence has been a spillover effect into boosting the market for BBB rated or lower-rated bonds.
During the middle of the COVID-19 crisis, BBB rated bonds made up more than half of all bonds issued. And, after the Federal Reserve’s announcement, BBB rated bonds actually made up a greater proportion of bonds issued.
“It raises concerns that the Federal Reserve’s intention to help borrowers access credit can create a corporate debt overhang problem,” says Associate Professor Yu.
“This is when a firm or company borrows too much, their debt obligations crowd out future dividends. Shareholders will become reluctant to forgo current dividends to invest in firm growth because they anticipate that most of the future cash flows will be used to pay debtholders. For BBB or high yield bond issuers this debt overhang can kick in which can potentially generate an effect to work against any economic recovery.”
One method to fight this debt overhang problem is to design debt contracts in the way that financially distressed borrowers are able to restructure the debt by renegotiating with corporate lenders.
“They can restructure a firm’s capital structure so that leverage can go down by, for example, a debt-equity swap,” he says.
However, unlike a bank loan which is easy to renegotiate as there is usually just one bank or group of banks to negotiate with, publicly held bonds are much harder to restructure.
“For bonds, you can have a large number of investors. Coordination problems among such bondholders can impede efficient debt restructuring,” he says.
“It means that it becomes difficult to deal with this corporate debt overhang. This is something that corporate executives, investors, and policymakers need to be aware of now.”