Corporates Insulated But Not Immune From Sovereign Bond Malaise
BMI View: The rise in Japanese government bond yields has led to higher private sector financing costs, which could eventually pose a risk to corporate financial stability and capex plans. While higher interest costs will likely be a drag on corporate expansion plans, data shows that the corporate sector appears relatively resilient, with liquidity and solvency ratios having improved greatly in recent years as the use of debt has fallen. The largest risk to the corporate sector comes from the negative growth shock that a fiscal crunch would cause, in our view. As further debt reduction from the corporate sector becomes increasingly difficult, the Bank of Japan's (BoJ) policy to revive inflation is likely to work.
The rise in Japanese government bond yields has raised concerns that the corporate sector will face a rise in instability as interest rates rise. Indeed, as sovereign yields provide the benchmark for corporate yields, higher JGB yields (which we continue to expect) will push up borrowing costs for the private sector. This has already begun to take place, and the recent news of Toyota Industries and JFE holdings delaying their bond issuance due to higher yield volatility has further fuelled these worries. Bank of Japan (BoJ) Governor Haruhiko Kuroda recently dismissed these concerns, although he conceded that the central bank would monitor the movements and respond through its market operations at a relevant pace. We believe that the corporate sector is relatively well placed to cope with higher rates, on the whole, and we do not envisage large-scale bankruptcies. However, expansion plans are likely to be wound back should we see interest rates rise substantially or volatility remain high.
|Upwards Spiral Bodes Poorly For Corporates' Expansion Plans|
|Japan - 10-Year Government Bond, % Yield|
Rising Interest Costs A Risk To Capex Plans
Looking at the average measure of the largest 100 companies on the Tokyo Stock Exchange Index (TOPIX100) and similar metrics for the smallest 500 companies on the index (TOPIX Small), over the past decade, the average debt-to-asset ratio has declined for both the groups, although large firms continue to use more debt than small-sized firms. This trend of debt deleveraging has persisted despite a reduction in interest costs (implied using an average tax rate of 38%, without negative depreciation and tax liabilities/assets), suggesting that increasing interest costs will likely further discourage firms to undertake debt-financed expansion plans, undermining economic expansion over the medium term.
|Existing Debt Not A Major Risk To Corporates|
|Japan - Debt-To-Asset Ratio (RHS, %) & Interest Cost-To-Cash & Equivalents (LHS, %)|
Improved Balance Sheets Suggest Greater Resilience
Although the rise in interest rates will dampen the demand for new loans and adversely affect firms with thin or highly volatile cashflows, companies on the TOPIX have actually seen a strong increase in their abilities to withstand a rise in interest costs. Annual interest costs as a proportion of operating cash flow and cash and equivalents are now close to the lows recorded in the past decade. This improvement in liquidity and solvency ratios suggests that companies are likely to be relatively resilient in the face of a rise in interest costs.
Corporates At Risk From Fiscal Crunch
While we acknowledge that the corporate sector will be adversely impacted rising interest rates, we see greater risks stemming from shrinking government spending as a spike in public borrowing costs forces authorities to cut back. In order for the government to avoid a fiscal crisis, tax rates will need to rise and spending will have to be cut, and both of these things will weigh heavily on corporate profits. If these fiscal cutbacks are not made, on the other hand, a major spike in interest costs could pose an ever larger threat to the corporate sector as national wealth takes a hit from the fall in government bond prices.
BoJ To Get The Inflation It Wants
We believe that the acceleration of price inflation that the central bank hopes to achieve as it doubles the country's monetary base is highly likely to materialise. As the corporate sector has already undergone extensive debt deleveraging over the past decade, further declines in debt (thus money supply contraction) will be difficult to achieve. The natural deflationary force of deleveraging has largely played out, and the inflationary force of rising bond purchases and high fiscal deficits are likely to become the dominant force over the coming years.
|Sharp Falls Highlight Concerns|
|Japan - Tokyo Stock Price Index (TOPIX)|
Loss Of BoJ Control Could Weigh On Equity Markets
The recent plunge in local equity markets suggest that investors could be concerned that the BoJ may lose control of the debt market, which could result in a disorderly spike in yields. The Nikkei has been the top performing developed market equity market since we called for outperformance in November 2012. However, we believe that this outperformance has largely played out, and while we could see another near term high in the market, the risks are weighted to the downside owing to the growing fiscal concerns.