Risks Related to Growing Corporate Debt Levels
Category: Portfolio Management
Former Vice President Dick Cheney famously argued in 2003 that deficits don’t matter. While most of the GOP-led Freedom Caucus may still disagree, the political consensus seems to have come around to Cheney’s view. Case in point: the $22 trillion and rapidly rising US government debt now exceeds 100% of GDP and several times that level if one includes unfunded entitlement liabilities. Just as alarmingly, the New York Times recently reported that many mainstream economists are now embracing the same “debt is good” views espoused by long-time progressive economists such as Paul Krugman.
Yet, history and common sense tell a different story. Debt has been at the heart of virtually every financial crisis in history and the US is likely on a trajectory where debt investors will eventually refuse to lend at rates that do not crowd out other funding needs. There is simply no clear sense of when that will be. As former Fed Chairman Alan Greenspan said at a Morgan Stanley Investment Management conference late last month (paraphrased), “Outsized deficits have eventually led to inflation and slower growth in every instance that I’m aware of. Politicians typically do not care about deficits until they trigger that inflation. From a central bank perspective, any hint of slowing growth and rising inflation—or something worse such as bona fide stagflation—is perhaps the single most difficult set of variables to deal with, so as a country you want to do all that you can to avoid it. This cycle has been unusual in that inflation hasn’t taken root in a worrisome way. . . yet. But the increase in debt is simply unsustainable without significant repercussions.”
US investment grade debt has more than doubled to nearly $5 trillion since 2008, roughly half of it in the most speculative BBB rungs. High yield plus BBB-rated debt now comprises over two thirds of outstanding US corporate bond debt. In the post-financial crisis world of quantitative easing, this should come as a major surprise to…absolutely no one. Finance 101 classes throughout time have made the case that when the cost of debt is lower than the cost of equity, use debt to buy back equity. The good news is that the cost of most of that debt has been historically low and the maturity has been historically high. Additionally, the median interest coverage ratios for investment grade and high yield remain healthy by historical standards. Moreover, corporate issuance fell about 12% last year due in part to the 2017 tax changes. It is positive that much of the high yield and loan issuance since 2008 has been refinancing existing debt at lower rates. The spread between BBB bonds and 10-year Treasuries has also widened to more normal levels after being exceptionally tight a year ago.
The euphemistic not-so-good news is that recessions are inevitable if not highly predictable. Simply put, historically high corporate debt levels, particularly in the lower credit quality rungs, could make a “normal” recession significantly worse. Signs of excess from the prolonged period of low rates since the financial crisis abound, including dramatic increases in leveraged loans (most of which have covenant-lite structures) and collateralized loan obligations (CLO’s). The unusually high levels of BBB debt pose a risk simply because many pension and mutual funds could become forced sellers if the debt gets downgraded to junk status.
The recent regulatory changes that have dramatically reduced the bond trading activity at the major brokerage firms seems likely to exacerbate any fixed income liquidity crisis. The liquidity mismatch due to the rise of daily liquidity ETF’s and passive vehicles for relatively illiquid and opaque high yield and loan markets is cause for concern. It is also unclear how the rise of passive investing will impact liquidity in a bond market crisis—the topic of a lively, albeit seemingly premature, YouTube-worthy CNBC debate between Larry Fink and Carl Icahn back in 2015 . As Baupost’s Seth Klarman recently noted, after a 36-year bond bull market, most of today’s market participants have never experienced a bear market. They may not fully understand the risks embedded in their positions.
In sum, liquidity risk may be a larger worry than credit risk this time around. But history is clear—financial accidents tend to occur more frequently in periods of excessive leverage.