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THE ECONOMICS OF THE PRIVATE MARKET

Evidence That a Credit Crunch Occurred

Recent events in the below-investment-grade segment of the private placement market qualify as a credit crunch because gross issuance or originations for below-investment-grade debt declined substantially and spreads on such debt increased sharply, whereas spreads on investmentgrade private placements held steady or declined.  A general increase in the riskiness of borrowers cannot account for these phenomena. The decline of issuance may have been accomplished partly by nonprice rationing, but we have no quantitative evidence to support such a claim, and market participants' remarks about nonprice rationing were mixed.

Data from three separate sources confirm a reduction in issuance of below-investment-grade private placements. First, gross issuance by below-investment-grade, nonfinancial corporations fell more than 50 percent in 1991, a much steeper drop than that seen in issuance by investmentgrade corporations (table 12). ¹⁴⁷  As a percentage of gross offerings, below-investment-grade issuance declined from 16 percent in 1990 to 9 percent in 1991. Data for 1992 indicate that issuance remained depressed, although the percentage was slightly above that in 1991. Second, although total commitments by major life insurance companies to purchase private placements remained roughly constant from early 1990 through mid-1992, the proportion of below-investment-grade issues dropped sharply in the middle of 1990, from 21 percent in the first half of 1990 to 11 percent in the second half of that year. Since then, the percentage has varied between 31/2 percent and 71/2 percent (chart 16). ¹⁴⁸  Third, the reduced rate of gross purchases indicated by the survey is also evident in insurance companies' holdings of below-investment-grade securities. Holdings of such securities at all life insurers fell 11 percent in 1991, whereas holdings of investment-grade securities rose nearly 12 percent.  As a result, speculative-grade private bonds as a percentage of all private placements in insurance company portfolios declined from 19.8 percent in 1990 to 16.7 percent in 1991. The low rate of commitments to purchase below-grade private placements in 1992 led to a further decline in their share to 15.3 percent last year.

Accompanying the decline in gross issuance and outstandings has been a sharp increase in yield spreads on below-investment-grade private placements. According to market reports, before 1990 the difference between yields on BB- and BBB-rated private placements with comparable terms was about 100 basis points; since then, the difference has been as high as 250 basis points. ¹⁴⁹  Although data are unavailable for periods before 1990, the relative movement in yields on BB and BBB private bonds is confirmed in the spreads reported in the ACLI survey (charts 17 and 18). ¹⁵⁰  During the first half of 1990, the spread between yields on BB private placements and comparable Treasury securities was about 300 basis points, compared with 190 basis points on BBB private placements. From that time, the spread on BB bonds moved up to almost 425 basis points in the second quarter of 1991, but more recently it has retreated to around 350 basis points. During the same period the BBB spread drifted down to 180 basis points. Similarly, the spread on A-rated private placements varied little over the past three years. ¹⁵¹

The substantial increase in spreads over Treasuries for BB private placements cannot plausibly be attributed to a general increase in risk associated with the slowdown in economic activity because such an increase in risk should have also led to an increase in BBB spreads. In fact, those spreads declined. Similarly, although the slowdown might have caused issues to be more concentrated at the low-quality end of the risk range that each rating category spans, leading to an increase in average spreads for each rating category, such a mechanism should have affected both BB and BBB spreads. The data thus indicate that, within the below-investment-grade segment of the private placement market, for a given level of risk loan prices went up whereas the volume of loans went down. These facts support our assertion that a credit crunch occurred within that market segment.

16.  New commitments to purchase below-investment-grade placements as a percentage of total commitments by major life insurance companies, 1990-92

17.  Yield spreads on privately placed corporate bonds, 1990-92¹

18.  Difference between BB spread and BBB spread, 1990-92¹

12.  Gross issuance of private placements by nonfinancial corporations, 1989-92¹

147. Estimates of issuance were constructed from data obtained from IDD Information Services. Gross issuance excludes offerings to finance employee stock ownership plans (ESOP) and restrucEagleTraders.comgs. Underlying developments are more evident with their exclusion, as both were heavy in 1989 but fell off sharply in 1990 and 1991. Before 1990, ratings reflect the judgment of agents supplying information on transactions they placed. Thereafter, ratings assigned by the National Association of Insurance Commissioners are available.

148. Commitment data are from a survey of major life insurance companies by the American Council of Life Insurance (ACLI). Respondents to the survey hold approximately two-thirds of all private placements in the general accounts of life insurance companies. The survey began in 1990, so earlier data are not available for comparison. However, at year-end 1990, the twenty largest life insurance companies reported that 20.1 percent of their private placements were below investment grade. Hence, the 21 percent share of private placement commitments going to below-investment-grade bonds in the first half of 1990 probably was similar to earlier rates of acquisition of such securities.

149. BBB-rated bonds are investment grade, whereas those rated BB are below investment grade.

150. Care must be used in interpreting the reported spreads.  Although they are transaction prices, they do not reflect a standardized security. The nonprice terms of private placements can differ widely for bonds carrying the same credit rating, and the terms affect the yields. For example, at any given moment, the difference in spreads between the highest-risk BB issue and the lowest-risk BB issue may be as much as 150 basis points.  Under normal circumstances, averaging spreads within a rating category produces a representative spread for that rating.  However, as most of the BB bonds issued since mid-1990 probably were at the least risky end of the BB risk range, the increase in the BB spread shown in chart 17 probably understates the actual increase.

151. In the public high-yield bond market, spreads increased sharply from mid-1989 through 1990 but have since fallen significantly, though they remain above the levels that prevailed in early 1989. Issuance of public junk bonds stopped almost completely during 1990 and most of 1991 but surged in 1992 to the second highest level ever. Thus, experience in the public junk bond market has been significantly different from that in the market for below-grade private debt.

Sources of the Credit Crunch

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