Macro

The decline in US interest rates by the Federal Reserve to combat the GFC has left a mark on the investment landscape and triggered the rise of a new bubble – the Corporate Debt Bubble, which now poses risks which many prominent investors are now flagging.

In today’s blog, I want to analyse this phenomenon and discuss its potential implications.

Main Points

  • An unprecedented level of indebtedness has been achieved in the United States. Much of the debt is from the riskier tiers of the spectrum.
  • Despite lower interest rates, US corporations are more exposed to a financial shock now than before the GFC.
  • The risk is that this may result in a mild recession. If this occurs, we believe that the financial market crash will be severe.

How we got to this point

As discussed in my last blog on Livewire, there has been a considerable level of debt issuance in the US by nonfinancial corporations in the aftermath of the GFC.

Such an occurrence was perhaps no surprise – once the Federal Reserve lowered interest rates to near 0 (and as such low-risk bond and deposit rates were cut), investors attempted to seek yield from more risky places including investment-grade corporate bonds.

But there was only so much ‘investment grade’ to go around and when that was sold, more was created – largely from the very lowest tier of the investment grades. Notice how the BBB tier is now over 50% of all US investment-grade corporate bonds. By contrast, it was about 30% in 2008.

And once yields from those bonds weren’t enough for some, then high yield debt became in demand. In fact, investors have been so keen on high yield bonds that now the spread between these and investment-grade AAA corporate bonds is about 1.5%, down from circa 5% at the start of the decade.

The spread between the 10-year government bond and high yield bonds has also contracted from over 5.5% at the start of the decade to about 2%.

So effectively, investors have been willing to take more risk for less return. Part of this is of course due to lower inflation which has been on average 1.4% lower by our estimates, but we can’t ignore that real yields have also fallen.

Implications

If the companies have become less risky, then they should pay lower rates on debt and the above trend could be easily explained. Further, with lower interest rates today, companies should have more earnings relative to their interest costs which would make the debt less risky.

But we don’t believe that this is the case.

In a recent study, Deloitte found that companies have not improved their debt serviceability and thus haven’t become less risky. In fact, companies have used lower rates to leverage up their balance sheets. So much so that serviceability has actually fallen.

(Serviceability is generally referred to as the number of times EBIT can cover interest expenses, i.e. EBIT/interest expense).

Since interest rates have fallen, this should reduce interest expense and increase the number of coverage times. But instead, the coverage has fallen.

This means that many companies are now more exposed to an economic shock in terms of their coverage ratios than back in 2007 (and this is with lower interest rates having been factored in).

We’re not the only group who has cottoned on to this risk, indeed many would’ve read the warnings from DoubleLine Capital and Schroeder’s. Both the Bank of International Settlements and the International Monetary Fund have also expressed concern about both the quantity and quality of corporate debt being issued.

PIMCO has also raised red flags and then went even further in its 2018 report, explaining that in periods of future economic weakness, many investment-grade bonds may be subject to downgrade risk i.e. the bonds moved from a rating of BBB to something less than investment grade (i.e. junk status) which are harder to refinance.

The problem with this is that many companies rely on this debt to fund their day to day operations and thus the rollover is an absolute necessity to remain a going concern. Kerry Craig of JP Morgan noted in his April blog to Livewire that 60% bond issuance has been used refinance existing debt so this obviously is an issue worth keeping an eye on.

If companies do go under on a large scale, it will create a widespread drop in demand for goods/services as well as unemployment which are all contractionary variables as far as the economy is concerned.

Many bonds in the riskier tranches are also ‘covenant-lite’ meaning that investors have little protection or recourse in the event of a default.

And further, a lot of this capital has been used to pay special dividends, engage in M&A or do share buybacks as opposed to reinvesting in productive assets which could be used to sustain debt service.

But so far there’s been no problems. And with an interest coverage ratio of >3, most companies can easily cover their interest payments, investors are happy to roll over the debt and there’s little to worry about.

It’s a typical case of everything will be fine until it’s not. And the ‘not’ part could be soon…. but also years away. So how do we think about this?

Global risks

We live in a globalised world where economies are connected. It’s the living embodiment of Maynard Keynes’ ‘we’re all in this together’. China and Europe seem to be having problems and there is a risk that these countries export back their contractionary trends to US companies.

On the numbers, Europe appears to be flirting with recession (Germany and Italy seem to both be incredibly close to a recession) and China’s slowing growth is well noted. Adding to the issues in Europe are Brexit and the ECB’s inability to stimulate long-lasting economic growth despite multiple years of stimulatory measures.

Tariff escalation is a contractionary measure and would not help the situation. Unfortunately, I think Michael Ivanovitch (in his recent piece for CNBC) is right which he says that there’s no way that China can give Trump the trade deal he wants, and thus, said escalation is a plausible scenario.

The Federal Reserve is aware of these trends and the NY Fed’s own modelling is flagging the highest likelihood of a recession in the next 12 months since the GFC. Hence why many Fed Board members are open to near term cuts in the fed funds rate as a buffer against the global headwinds.

But even the Fed isn’t entirely prepared. Back in March, The Board of Governors voted 4 to 1 not to mandate countercyclical capital requirements (a policy whereby financial institutions are required to set aside extra capital as a buffer when the economy moves into the later stages of the expansion cycle).

My concern stems from the risk that these contractionary trends weaken the financials of many leveraged US companies and cause defaults, or at least create a more picky appetite from investors in deciding which companies will be able to roll over loans. The issue is significant enough that if enough companies fail, macroeconomic indicators such as unemployment will be effected in the US and this could send the country into a mild recession.

When the recession hits, I don’t think it will be as severe as the GFC. From what we can see, the risks of the corporate bond bubble are less systemic than sub-prime was in 2008 and households are not as leveraged as they were previously.

However, we are expecting a large correction in the financial markets as a lot of the financial engineering of the past decade unwinds (for reasons I discussed in my last blog on Livewire).

Vega’s macroeconomic model has been raising flags since the beginning of 2019 – warning of upcoming global weakness and we’ve now seen the beginnings of that. We’re still (very) conservatively long market exposure as well as volatility. Yet we do have the intention of calling an outright short on global markets should economic conditions severely weaken further.

To wrap it up

Economies and markets operate in cycles of which we're simply experiencing another. 

And it's not all bad news. Like in prior cycles, the malinvestment is washed away allowing fresh capital to be redirected to concerns which have brighter and more solid long term prospects.

After the crash, there will be a recovery. Both are opportunities for investors to consider. 



Comments

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Mark Dawson

An excellent blog thanks Scott. Hopefully us as investors are better prepared for the next market crash. Last time I was caught out, this time I'm better prepared or at least I like to think so. I've rebalanced my portfolio into defensive stocks carrying little debt and good management. I also brought into a few Gold producing companies like North Star and some gold ETF's before the price moved North.

Trevor Easterbrook

Scott a well researched and though provoking piece. Timing of how this unfolds will likely be quick and blind side most investors.