It’s time to revisit our financial condition assumptions

Good morning, dearest gentle reader: a greeting you may not be familiar with, unless you’ve watched Netflix’s saucy regency-era television series, Bridgerton.

But if you haven’t seen it yet, Netflix’s latest results suggest you’re out of the loop. It’s now one of the media group’s top 10 most viewed programmes of all time.

That and other recent successes lifted subscriber numbers by 8mn in the second quarter, with revenues jumping 17 per cent to $9.6bn. Still, the company expects this quarter’s subscriber additions to be lower than a year previously, when it first fully cracked down on password sharing.

Any thoughts on the state of the streaming industry or your favourite shows — get in touch with me at [email protected] while Rob watches sumptuously trashy TV on a sunlounger somewhere.

Financial conditions: not so easy?

Companies issued a stonking $1tn of debt across the US investment-grade and high-yield bond markets in the first half of this year, according to data from PitchBook LCD. That marked the highest total since the borrowing frenzy of 2021, when interest rates were practically non-existent.

Despite that huge wave of new issuance, massive demand for new corporate debt — fuelled by yield-hungry investors — has helped to keep a lid on borrowing costs. On average, junk-rated borrowers pay just 3.09 percentage points to issue debt over US Treasury yields, Ice BofA figures show, down from 3.9 percentage points a year ago. High-grade bond spreads average just 0.93 percentage points, down from 1.28 percentage points.

In essence, markets have been very accommodating, making it easier for US companies to borrow, even before the Federal Reserve begins to cut interest rates from their 23-year highs. Exemplifying that openness, the Chicago Fed’s National Financial Conditions index last week reached its loosest level since November 2021.

Why do we care? Well, some might worry that these figures reflect over-exuberance in credit markets, which could ultimately encourage too much risk taking — meaning lenders fail to exercise necessary caution, complacently funding companies with weak growth prospects that might ultimately struggle to service their debt.

As Citigroup’s Michael Anderson puts it: “We care about financial conditions because they have important implications for growth, important implications for monetary policy and also for future default rates. If financial conditions get too loose, and lenders get over their skis in terms of risk, we could see a spike in default rates.”

Overly loose conditions might also dissuade the Fed from making the two or three quarter-point rate cuts this year that markets are currently pricing in.

However, the financial conditions picture is more complex than the broad metrics cited above suggest. At an index level, things might look very loose — but under the surface, I’m inclined to agree with Anderson that it’s truly a “mixed bag”.

For one thing, as he highlights, overall leveraged buyout activity has picked up this year — but it’s still well below the highs seen in the immediate aftermath of the Covid crisis, when central bank stimulus fuelled a borrowing frenzy.

In fact, the share of junk bond issuance in the first half of this year done purely for refinancing purposes was its highest since 2009, as companies and their private equity backers chose to roll over old debt instead of feverishly pursuing M&A deals.

At the same time, while debt issuance did get off to a roaring start this year, weaker borrowers have failed to join the party to the same degree. Issuance of US junk bonds ranked triple-C or lower by at least one rating agency — the bottom end of the credit quality spectrum — totalled just $11bn in the first six months of 2024, according to PitchBook LCD data. That was up slightly from 2023’s very muted levels, but down more than one-third from the same period a year earlier.

By contrast, issuance of junk bonds rated double-B or single-B jumped by about three-quarters in the first half of this year to roughly $150bn.

So, the borrowing window has stood wide open in 2024, unless you’re a company with very risky debt, facing numerous macroeconomic and idiosyncratic problems. A couple of sectors repeatedly pointed to in relation to such challenges include healthcare and telecoms.

I’d argue that signs of careful credit selection — and general avoidance of weaker companies — are also evident in the secondary market, where investors trade assets with each other.

The average spread for a US junk bond rated triple-C or lower sits at roughly 9.3 percentage points, up from 9.2 percentage points a year ago. By comparison, bonds rated double-B — the highest rung of high-yield — pay an average borrowing premium of 1.8 percentage points, significantly lower than a level of 2.5 percentage points last July.

Investors do appear to be treading (or trading) more carefully than those overarching gauges of borrowing conditions would imply. Looking at the data, accusations of blind enthusiasm would be unfair, or at least premature.

That may give way to less caution, of course, if and when the Fed eventually chooses to cut rates. However, there’s also an argument that a rate cut could prove restrictive for borrowers who have benefited from loose conditions up until now.

As Anderson at Citi points out, if the central bank does opt to ease monetary policy, private-equity sponsors might feel inclined to chuck more debt supply at the market — creating a technical hurdle that pushes overarching credit spreads wider, and counter-intuitively making it more expensive for companies to borrow.

Remember, he says, that “this cycle is not normal; things are turned upside down relative to what they have been historically, so you can’t just rely on one or two simple metrics to get the whole picture”.

Words that could be applied to a number of asset classes and scenarios these days.

One good read

Ken Griffin has bought a stegosaurus fossil called “Apex” for $45mn. A slightly more apt name than those given to other dinosaur relics (eg “Sue” and “Stan”.) Lots to “dig” into here.

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