Troubling signs in corporate debt

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0:35Pushkin.

1:03has run itself into a sticky patch. This all makes you wonder, has the corporate debt market overheated? This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm Katie Martin, a markets columnist at the FT in London, but I'm actually in New York this week. Hooray! Hooray! Giving an address to the UN. No, hanging out with the big fella, Rob Armstrong, from the Unhedged newsletter, The Daily Newsletter for discerning markets dorks. Rob, my first question. It's great to have you tease me face to face, Katie. That's the point. I was getting tired of being mocked from 3 ,000 miles away.

1:46Tell me, why is it so hot here? It's very, very hot. It's very hot. September is still summer in New York and it is still humid. I hope you didn't pack a sweater or, as you would say, a jumper because you will not need it here in New York City in September. I didn't pack a jumper, but I did pack a suit to wear at an event tomorrow, which I think error. I'm going to be wearing a suit tonight and I'm going to be sweating. But Katie, I'm going to be looking good. You reckon? Yeah. Now listen, Rob. It is never good when the top of the FT homepage has big stories about credit going wrong. Allow me to tell you what's in the current story at the top of our homepage from our colleague Eric Platt and also Robert Smith in London.

2:34U.S. debt investors have raised the alarm over lax lending standards in credit markets after the unraveling of two companies that just two weeks ago were deemed to be in strong health. Uh-oh. Ruh-roh. And as all discerning problem connoisseurs in markets know, the credit market is where the bad stuff always happens. Always happens. So let me just carry on from this story. So I'm paraphrasing a little bit. Tricolor Holdings, at the start of this month, appears to have failed. And First Brands Group is looking at bankruptcy proceedings. The thing is, Tricolor had a triple A rating when it borrowed in credit markets.

3:16Yes. Very recently, basically, the people who examine who's borrowing what under what terms say, yep, this is a very solid company. Really solid. Super solid. First Brands seems to have amassed as much as$10 billion in debt and off-balance sheet financing. Yikes. And it almost raised some more last month. So let's start with First Brands. Okay. What the hell is Burst Brands? Okay, Burst Brands is a very simple thing. It is a company that produces car parts, which is a very normal, real economy thing to do. It is also, it is worth noting, what we call a roll-up in our world, which means it started out making just one or two kinds of car parts, but then it got a hold of some financing to buy other car parts.

4:04So I can't remember what exactly it was, but maybe it was spark plugs and then it went to windshield wipers and then it went to catalytic converters or whatever it is. In general, roll-ups end in one of two ways. Either they make the owners very rich because they become these very powerful, horizontally integrated businesses that dominate their industry, or they borrow$1 too much or more often more dollars than that and they blow up in a blaze of glory. And like they kind of get addicted to buying other companies and borrowing money and growing inorganically and they kind of fly off the rails.

4:44And this company, First Brands, seems solidly in the fly off the rails category. Yeah, yeah. Whereas like Tricolor is a very different sort of business. And this is interesting in other ways. So, again, it's not exactly a household name, particularly outside of the States. But as I understand it, it lends money for people with low credit ratings, like generally low income people to buy cars. Yeah. It actually sells the cars too. So it has used car lots under its own name and other names. And it sells you the car. But like a lot of car dealerships, they actually don't make their real money on the cars.

5:28They make their money on the loan they sell you to buy the car with. And not only did Tricolor specialize in low credit ratings, it specialized explicitly in borrowers who didn't have social security numbers. And that means immigrants. In America, unless you live in New York City, you have to have a car. So if you are an immigrant, documented or on social security number or green card or no, you need a vehicle to get to work. Right. And this company specialized in lending money to those people. And for a long time, they were pretty good pays. And that went along fine. But this stopped going along fine.

6:12For reasons that are pretty obvious, right? A lot of these people have stopped going to work. Yeah. Because they don't want to get rounded up by immigration officials. Or maybe they've just left the country and what happened to their car that they bought while they were here was not top of their list of concerns. So it sort of makes sense. And we have heard some kind of minor sounds from other businesses that the immigration crackdown was causing some pressure from certain consumer brands or so forth. But this, as far as I know, was the first good-sized business that has really looked like it's gone into bankruptcy and slash is failing.

6:54So I spent my morning in New York doing a couple of meetings with people I've been meaning to catch up with for quite a long time. And they were pointing to both of these examples and saying, look, there isn't necessarily a straight line between these two things. but this just is a little, it feels a little bit like a canary in a coal mine. It's something that - Two canaries. Two canaries. What is the, you know how like animals have the, have like a collective noun, like a murder of crows? Is it not just a flock of canaries? No, I think it's something more colorful. Like how it's a parliament of crows.

7:30Exactly, precisely. Anyway, multiple canaries. Yeah. The people in markets are keeping an eye on just in case this is the first start of stress in the credit markets because we spend a lot of time on this show talking about stock markets because people understand stocks pretty well. They go up, they go down. Simples. Credit markets are a little bit more complicated than that. And forever, when people have talked about corporate bonds, they've talked about what the gap is between the yield you get on a corporate bond and the yield you get on government bonds. So what kind of return do you get on those two types of bonds?

8:07For the extra risk you're taking of lending to a company rather than the government, which has the printing press, so we'll definitely pay you back at least in nominal dollars. Yes. So in theory, you as an investor should be getting paid a lot more money to take corporate risk than you do to take government risk. Because as you say, governments can always pay you back because they can print the money if they really, really have to. But what's happened particularly over the past couple of years is those spreads have just vanished. Like you get paid almost nothing more to lend to a company, particularly a safe company in what you call investment grade markets.

8:45But even to a large extent in high yield markets, which is also known as the junk bond market, which is riskier companies. That gap, that extra dollop of cash that you get has just shrunk to levels that no one has seen for decades and decades. Okay, here is the Bank of America ICE U.S. high yield index spread, which is a kind of a big generalization about how much interest extra you get paid for lending to quite a risky company. And as recently as three years ago, you got about 6 % more. Six percentage points more. Six percentage points more. So that's okay. That's a lot. So for a five-year corporate bond versus the five-year treasury, you're getting an extra 6%.

9:32Now we have hit 2.7. So the spread has been cut by more than half, which is like the stock market doubling in a way. Yes, yes. And so huge move. And if you bought those bonds back in the summer or early autumn of 2022, you've made a bundle of money. You've made a bundle of money. Now, so I'll tell you something else from Bank of America. It's funny you should bring that up because they do a survey of credit investors. And in the credit investor survey they put out the other day, they said, quotes, a mammoth 59 % of investors are now overweight credit, which means they're holding more credit in their portfolios, more corporate debt in their portfolios than they normally would.

10:14And they said that basically means correction risks are rising. So when everything is priced so richly and everybody's in corporate bonds, it wouldn't take very much to make a lot of investors turn around and say, hmm, is this a good idea? Or should I take the profits that I've made over the past couple of years, which have been brilliant? And should I just pack up and go home? That's why little things like funny little esoteric problems in subprime auto lenders and funny little, you know, financial problems at windscreen maker manufacturer type people that have been big borrowers in debt markets.

10:56Those are the sorts of things that make investors say, hmm, is this a canary? Okay, in the case of tricolor, and there has been something of a debate in the U.S. office about the correct pronunciation of this name. Is it the very American tricolor or the more European or Latin flavored tricolor? Tricolor. Anyway, if you are a credit investor, there is a way you could write off tricolor as anomalous and not reflective of broader markets. It is a company that catered to a very specific audience that the president of the United States is trying to throw out of the country. Yes. This sounds like a one-off.

11:40This sounds like idiosyncratic risk. Now, with first brands, I think the situation is a little bit more complicated. And it's complicated in part because, as you suggested at the beginning of the show, it's tied up with the new darling asset class of all Wall Street, private credit. I think a big part of the problem, as far as I can tell, at First Brands was that not all of the lenders knew what the other lenders were lending. Oh. Right? So lenders may have thought they had a full picture of the capital structure of this company, and it turned out they did not. Now, whether that is due to carelessness, deception, poor planning, or whatever, at this point, we can only speculate.

12:30Yeah. But there's two big chunks of lending here. And now we're going to get a tiny bit technical. So everyone put on your thinking cap. The first big chunk of lending to first brands and its car parts was quite standard corporate syndicated lending, which means this is general money for you to run your company. I am going to lend it to you. then I'm going to take the notes or like your obligations and I'm going to securitize them and sell them into a semi-public loan market. And what sort of companies do that? Is it like private equity firms? No, no, no. This is like something that operating companies do.

13:12Like if you're a credit card company, you take all the credit card receivables, that means your debt and my debt, and you chop them up into little pieces and you put them into the market in a bond like a CDO, a collateralized debt obligation. And this is totally standard behavior. Now, so they're lending money to first brands. They're chopping up the debts. They're selling them into the loan market, all very normal. However, so that's about$6 billion. However, there was another$4 billion of debt rattling around inside this company. And that debt was debt that first brands took against its working capital.

13:50So like many companies do, They said, look, we've sold to a supplier. They haven't paid us yet. Lend us money against that receivable, right? We'll get the money later. You give us the money now. We'll pay you when we get paid. Alternatively, they were borrowing money to pay their suppliers. So they were doing the opposite on the supplier end. Anyway, it turns out they went a bit bananas, as you British people would say, with the amount of working capital lending they were doing. So there was another$4 billion provided by private lenders. So that's the fancy. And so, but maybe the people in the standard loan market didn't know what the private lenders were doing.

14:30And then there was a moment of realization when everybody realized this company has a lot more debt than we thought. So when it's all public bonds, it's very easy to tell, right? Because, you know, it's across all of your data screens. Here's a company issuing a bond. And even the loans, the loan market, which these guys played in, it's sort of semi-public, semi-private. You can't just whip up the numbers on Bloomberg, but you can look loan by loan inside the bond. Yeah. Right? I think we talked about this in the show the other week. When you have lots of flaky little borrowers and lenders suddenly getting into trouble just one after the other, and you write this one off as an esoteric story and you write that one off as an idiosyncratic shock.

15:17But it builds up just like it built up in 2006, 2007 when there were lots of companies that were making mortgages to people who couldn't afford them and they started falling over one after another and all of them were just sort of, you know, brushed off by the market saying, ah, yeah, but that was a special situation. Ah, yeah, but this one was bailed out by those guys so it didn't matter. And then one day it became too much to bear. Why I think this time is different, to use a cursed phrase, is that actually the private credit markets have been a really good shock absorber for credit globally.

15:53So they've taken on a lot of the companies that banks wouldn't lend to or that the big public bond markets wouldn't lend to. So they've taken out that riskier part of the market. So that's one of the reasons why investment-grade bond markets and high-yield bond markets, all the kind of standard bit of the bond market for companies, has been very well-behaved and in fact has squeezed those spreads lower. It's because all the risky stuff has gone somewhere else. And let me add something about this. And again, I'm going to get slightly technical here. So again, I have to ask listeners to put on their thinking caps a little bit.

16:29But there is important differences between a bank lending a company money and a private credit company, a private lender lending a company money. Here are the two key differences. One, the bank deals with a lot more borrowed money. So the bank is levered like eight or ten times, meaning for every dollar they lend out, they've got 20 cents of real money in the bank. at a standard private credit lender, it's 50-50. So that makes it less dangerous right there. The second thing is banks fund with deposits, which can go out the door very quickly. And the problem where you get with banks is when all the deposits leave on some random Tuesday, and you've still got all these loans and you blow up.

17:17The funding of a private credit company tends to be longer term. Yes. These are genuine differences between banks and private credit that help and are good. In private credit as well, when a company gets into trouble, the lender can say, okay, you've got yourself in trouble here. Why don't we restructure your debt? You don't need to make a big announcement about it. Not everyone needs to know. We can extend and pretend. And we can have that discussion without the incredible crushing pressure of public markets trying to drink your blood out of your skull. Exactly. One little wrinkle to kind of throw in at the end of this is over in Europe, obviously French government bonds have been under a lot of pressure lately because France is being France and having one of the political...

18:07I was going to say shit show. I think I'm going to stick with shit show. It's having one of the shit shows that it has. You can say that in France. Les présentations, merde.

18:18That's the one. And so French government bonds have been weakening a lot to the point where actually a lot of French corporate bonds are more expensive than the government bonds. And this is a strange reversal. This is like upside down world. It's not supposed to be the case that companies can borrow more cheaply than the government in which they're domiciled. Now, I said this either in the newsletter or on this podcast before. and listeners slash readers wrote in to say this has happened in the United States before. Like in the 70s, when it was cats and dogs living together in the United States and inflation was out of control and Jimmy Carter was there, IBM bonds had a lower yield than the equivalent US government bonds.

19:05So it has happened before, but it was the 70s when you couldn't park on the street because someone would steal your car every single time. But it's extremely rare. And it's one of the things that's happening in European markets at the moment that is really making people think, oh, hang on. The French government is really in a spot of bother here. My core expectation of the French government is it will do what it always does. Come up with some hodgepodge solution and things will be fine. But there will be some drama along the way. So what do you reckon? All told, is credit too expensive? Are corporate debt markets too happy for their own good?

19:43I think they are. I think a huge amount of money has rushed into the credit market very quickly. And when that happens, credit quality goes down. So I don't think these two companies are idiosyncratic. I do think we'll see more of this, especially if the U.S. economy continues to gently slow down, which it has been doing. But to pick up on your point, I don't see a systemic mess coming out of this because of the points you made about the structure of the credit market. I mean, we may get a systemic mess for some other reason, but I think the risk of a repeat of the systemic mess of not only 2008, but kind of Eurozone-y crises type things a few years after that seems pretty low at this point.

20:30Yeah, I think low, but I also think it just wouldn't take too much to push this market over. And I think you might end up with a bit of a correction that's not necessarily based on a piece of news, but just based on a bit of a wave of nerves that runs through the market. And some people who've made good profits say, do you know what? Maybe I'm tapping out here. And that's OK. And indeed, you might want to say if you were a long-term investor, a little of that would be healthy. Yeah. Right? You know, if we keep going like we have been going, we are going to get the massive forest fire. But a little brush fire might be OK at this point.

21:10Regular listeners may ask themselves why Rob doesn't have a similar conversation with himself about stock markets. But listeners, how worried are you? Let us know unhedged at FT.com. We'll be back in just one sec with Long Short.

21:34Speaking of alternatives, PGM's monthly podcast discussing trends and strategies in alternative investing. We've seen a lot of growth in the evergreen structures. They have become the most dominant structure within alternatives, supplanting the traditional 3C7QP closed-end fund. And we think that demand will continue, and that's making alt more accessible to wealth. hear the full conversation on pgim's podcast speaking of alternatives okie doke it is time for long short that part of the show where we go long a thing we love or short a thing we hate rob what you got i have just been informed by our brilliant sound man jake of the collective noun for a canary and it is the best collective noun I have ever heard in my life.

22:27Yeah. When you see a bunch of canaries, you do not see a flock. You see an aria. Ah, or an opera, Jake. Oh, incredible. An opera of canaries. That's perfect. If you've ever been around a canary, I mean, this is their, they are, they are like preening little opera singers and they're dressed up and it's just perfect. I tell you what. I'm long, I'm long those, those words. I'm willing to bet all the money I have in the world that Jake Googled that and did not know it off the top of his head. Yes, that's a safe bet. So that's cheating. Okay. I am short. Well, I'm long and short, but I think I'm short of going out drinking with Robert Armstrong, which is a possibility for Thursday night.

23:09I've got an early flight to catch on Friday. So it's all a bit upside down this week. We're recording this on Wednesday. The podcast is going out on Thursday. by the time this podcast goes out, I probably will be drinking with Robert Armstrong. This is the point of greatest danger to my life. So we should all hope that it goes smoothly. Pray for me, listeners. We will be back in your ears on Tuesday if we survive until then. So listen up then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. Topher Forhers is the FT's acting co-head of audio.

23:46Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.

24:19We'll be right back.