Below is a condensed version of an article from Fox Capital Management regarding the developing risk of corporate debt defaults. With a significant amount of maturities coming due in 2019 and 2020, we thought this perspective would be of interest.
Today, we here at Fox Capital believe a bubble highly vulnerable to collapse lies in the corporate debt market and the passive investment vehicles accompanying it. While C&I lending from the traditional banking system has been healthy since the last crisis ended, the corporate bond market has absolutely exploded, tripling in size from the peak of the prior cycle in 2007. As a direct result of the Fed’s zero interest rate policy, investors of all kinds were forced out on the risk curve, scrambling for yields attractive enough to meet their own obligations. Pension funds, endowments, insurance companies and retail investors (through ETF’s and bond funds) gorged on corporate debt for extra yield in a ZIRP world. Many of these yield-starved “shadow lenders” were new to the corporate debt market, and US companies were happy to tap this additional source of cheap money to lever up for stock buybacks, M&A and dividends given the immediate gratification of such financial engineering (higher stock prices).
Assets in the corporate bond ETF market have grown by over 10X since the last crisis. With no yield available in Treasuries, investors blindly piled into corporate bond ETF’s with the largest growth in Investment Grade funds (for example the LQD). Now, however, the Fed’s hiking cycle has made Treasury yields far more attractive, and the yield premium of corporate bonds (especially Investment Grade bonds) is beginning to look less appealing. This could create a reversal of capital flows back toward Treasuries, and indeed we are seeing early signs of that with Investment Grade bond ETF outflows accelerating already.
In addition to the impact a sustained reversal of flows could have on corporate bond pricing, corporate bond fundamentals are currently on a very precarious perch with US corporate leverage at all-time highs on many metrics. Further, the average interest rate for corporate America is set to increase next year for the first time since 2009, and nearly 50% of all corporate debt outstanding matures during the next 5 years, with the biggest y/y jump occurring in 2019. Most troubling is the fact that while the ratio of corporate debt to GDP has never been higher, corporate default rates have never been lower. This irrational phenomenon is a result of the Fed’s extended period of zero interest rate policy, though with a tightening cycle now under way, this historic divergence cannot last. These facts are largely ignored now that the economy is strong and corporate earnings growth and margins are at decade highs, but any small reversal of these “peak” fundamental metrics could introduce heightened volatility to the bond market quite quickly.
Parallels to 2008:
No financial crisis is ever the same as the prior one, as policy makers diligently prepare to fight the last war again with effective new measures. This backward-looking preparation unfortunately leaves them vulnerable to new challenges forming ahead. Many bulls argue that the banking system is far more robust and that consumer and mortgage debt is healthier than during the 2008 crisis, and they are correct. What they do not understand is that the bubble has now shifted to a new location, like water finding its own level. It will not be a consumer debt and banking crisis this time. It will more likely be a corporate credit and passive investment vehicle crisis, resulting in a bear market for stocks and bonds and a new cyclical economic recession.
The biggest similarity to the 2008 bubble (aside from its primary enabler – the Fed) is that investors are far too ignorant and complacent about the debt products they own. Today, it is the large amount of BBB-rated debt hiding in investment grade corporate bond mutual funds, and especially ETF’s, that is analogous to all those garbage mortgages hiding in AAA-rated debt product “innovations” during the housing crisis.
While BBB-rated corporate debt is considered “investment grade,” it sits on the lowest rung of the ladder. When BBB debt gets downgraded just one notch by ratings agencies to BB, it becomes a “fallen angel” and is reclassified from Investment Grade to High Yield (also known as junk). This is important because many investors, such as pension funds and certain bond funds, are unable to own debt rated below investment grade by charter, so should a wave of BBB downgrades occur, forced selling would be a natural consequence. It is also fair to assume that much of the investing public, especially ETF investors, could feel misled by the “investment grade” status of products they have acquired, and in turn would liquidate positions, especially with risk-free Treasuries now offering similar yields.
Exacerbating this particular risk is the fact that the BBB segment of the investment grade bond market has grown by 4X over the last 10 years, far outpacing overall market growth. At the peak of the last cycle in 2007, the total investment grade market was $1.7 trillion, and BBB-rated debt accounted for under 25% of the total. Since then, the investment grade market has ballooned to over $5 trillion, with BBB-rated debt accounting for over 50% of the total. In fact, when examining the entire corporate debt market, including Investment Grade, High Yield and Leveraged Loans, BBB-rated debt is the single largest component of the entire $7.5 trillion market. Again, should a wave of BBB downgrades to junk occur, it would now have a far more destabilizing effect given BBB-rated debt’s outsized portion of the market. The knock-on effect to the High Yield market would also be catastrophic, since even a small slice of the BBB market would swamp the much smaller and illiquid junk bond market with supply. While corporate health in terms of growth and earnings presently seems very sound, such a downgrade cycle could happen at any time due to the tenuous fundamental state of the credit market, especially with interest rates now on the rise.
Finally, unlike during last cycle, we expect that the ratings agencies will be far more proactive with downgrades when merited given how much scrutiny and criticism they faced ten years ago for failing to meet their responsibilities in the mortgage market. Several senior credit officers at both Moody’s and S&P have recently gone on record predicting a particularly large wave of downgrades and defaults in the corporate debt market when the next economic downturn occurs. We suspect these agencies will err on the side of caution in an effort to rebuild credibility, lowering the bar for a wave of ratings adjustments. As discussed above, it is the mountain of BBB-rated debt that has the biggest implications for a potential downward spiral.
(248) 646-9400 http://www.gccrisk.com
Source: Fox Capital Management