The media are warning that record corporate debt could be the mother of all bubbles with the potential to destroy the economy. Is it just hype, or should investors be concerned?
One of my favorite quotes by legendary investor, Warren Buffett, is also a bit off color: “You never know who has been swimming without their trunks on until the tide goes out.” The image of a man standing naked as the tide recedes is a bit jarring, which is why his famous metaphor works so well. It’s hard to unsee that image! Today, as the corporate bond market bubbles up under worrisome debt levels, you have to wonder if the tide will roll out again, revealing the bare behinds of overzealous bond investors.
Barely ten years have passed since the global financial crisis, but it seems its painful lessons have gone unheeded. With visions of the 2008 crisis dancing in their heads, the media, along with financial regulators and the Federal Reserve are expressing concerns over the extreme amount of debt building among U.S. companies. Over the past year, ominous headlines have been appearing in the financial media warning of the “mother” of all bubbles brewing in the corporate bond market, with the potential to destroy the economy.
With corporate debt surpassing $9 trillion in 2018, nearly doubling since the start of the financial crisis, the angst in the marketplace should not be dismissed. But, does it rise to the level of a crisis with the foregone conclusion of an economic collapse? Your answer may largely depend on whether you have a glass-half-full or glass-half-empty outlook. A stronger economy and healthier balance sheets could insulate affected companies, but a slowing economy and more expensive debt could drag them under.
How We Got Here
Ironically, the same quantitative easing that was employed to deleverage the economy became the impetus for companies to re-leverage. Companies took advantage of low interest rates to load up on cheap debt which was used to rebuild, expand and renew the faith of shaken shareholders with generous share buybacks. Many companies emerged from the financial crisis with stronger balance sheets, which put them in a better position to service the debt and renewed investor confidence created an insatiable demand for investment-grade corporate debt.
Then, in an effort to “normalize” interest rates, the Fed started raising rates in 2015, forcing government bond yields to climb and increasing borrowing costs for companies. In 2018, the average yield for investment-grade bonds reached its highest level since 2010. But, thus far, companies have been able to weather the headwinds of rising rates thanks to the low cost financing they were able to lock in in the early stages of the recovery.
Now, in the late stages of this economic cycle, many companies are heading into an impending maturity wall which will force them to roll over their debt in a rising interest rate environment and a looming recession. More than $4 trillion in corporate debt must be refinanced in 2019 and $11 trillion over the next five years. Absent the favorable forces that have been supporting their balance sheets, many companies will see their borrowing costs explode and the possibility of credit downgrade.
Are We Entering Uncharted Waters?
The current corporate borrowing binge should concern investors, especially when metrics demonstrate that the increased risk is not yet priced into bonds. If the sheer volume of debt is not enough to concern you, consider some of the ratios which may portend stormy seas ahead.
- Long-term debt to total capitalization of S&P 500 companies has increased from 35.59% in December of 2011 to 42.38% in December of 2018.
- That wouldn’t be as concerning if there was enough cash available to cover the increase. But the cash-to-debt ratio for corporate borrowers has fallen to 12%, the lowest point ever.
- Even more ominous is the record 60% of NASDAQ companies sitting on junk bond-rated debt that is maturing in the near future.
In these unchartered waters, the questions analysts are grappling with is what the appropriate metrics are to determine whether the current risks outweigh the potential rewards in the corporate bond market.
Reasons for Optimism?
According to Fitch Ratings, companies are spending a much larger percentage of incremental dollars on debt reduction with the 2017 Tax Cuts and Jobs Act creating a much needed bump in cash flows to pay towards debt. The top 100 nonfinancial companies have directed $72 billion of new cash flow to debt payments, sparking a trend that is seeing net borrowers turn into net payers of debt.
Fitch also notes a substantial year-over-year decrease in new investment grade and high-yield issuance from 2016 to 2017. Its forecast for bond defaults in 2019 is the lowest since 2013 and leveraged loans at the lowest since 2011.
Do the Risks Outweigh the Rewards?
Generally, it can go one of two ways. If the economy continues on a moderate rate of growth and interest rates stay about where they are, companies should be able to manage their debt through refinancing. However, if the economy slows and rates continue to rise, it will be tough sledding for companies.
Unlike the ocean tides, which can be predicted to the minute, we do not know when the U.S.
economy will turn down sufficiently to impact companies abilities to cover their debts. While we may not be at a point where this bubble is ready to burst, there’s enough risk that, in our opinion, has et to be priced into the market. For that reason, we recommend investors underweight corporate bonds, especially high-yield bonds where the risk of default is greatest.