The corporate debt unwinding scenario goes like this:
1) Shaky companies like Chesapeake energy, Ford, or GE leverage themselves to the max as an easy way to boost return on equity and EPS during a time when investors are reaching for yield. Under this capital structure, cash flow only covers interest payments if a few key assumptions all stay in place, such as low interest rates, no ratings downgrades, or commodity prices at a certain level. For example, a company may borrow at 4% to finance a project with 5% expected returns. If actual returns turn out to be 3%, or if the debt can only be refinanced at 6%, the project - or the company - will no longer make sense.
2) Key assumptions start falling for an increasing number of highly leveraged companies. Maybe their debt gets a surprise downgrade, or profits don’t materialize, or the liquidity is not there at refinancing time. As a result, they are unable to roll their debts at a low enough interest rate so that their cash flow can cover interest. E.g. imagine if your mortgage had to be refinanced every couple of years, and the worse your financial picture became, the higher your interest rate went.
3) Such companies are downgraded and an increasing number seek bankruptcy protection. Investors start to demand higher interest rates from other companies they fear might get downgraded or go bankrupt. This causes assumptions to fall and debt costs to rise for a widening sphere of companies.
4) Investors’ bond portfolios start to underperform, setting off a stampede away from lower-quality corporate debt and toward treasuries. The spread between yields on treasury bonds and corporate bonds increases. E.g if treasuries previouslyyielded 2% and corporates 3%, now treasuries yield 1.5% and corporates 5%.
5) An increasing number of leveraged companies go bust because investors will no longer loan to them at rates they can cover with cash flow. I.e. they attempt to refinance their bonds which are coming due, and are unable to find sufficient liquidity to complete the refinance. Therefore, when they must pay back hundreds of millions in maturing bonds and don’t have the cash, their only choice is bankruptcy or a negotiated default/restructuring. Simultaneously, interest costs increase even further for lightly-leveraged corporations, causing their profitability to drop and their expansion plans to be halted.
6) As corporate assets start to be shut down and liquidated, economic growth falls. Everything goes on sale and unemployment rises. The pace of bond defaults accelerates. This all creates a further feedback loop causing investors to demand more interest from their bonds. Spreads widen, causing corporate bond portfolios to lose even more.
It is very hard to successfully time the market on these things. Unusually high leverage has been a market feature for years, and the commodity bust of 2016 failed to ignite a predicted wave of defaults and higher interest rates. Imagine being the investor who has been sitting in treasuries for the past 4 years waiting for the business cycle to turn, despite plenty of good-sounding reasons to do exactly that! Agony!
