Most of us worry. We understand logically that we perhaps imagine more issues, problems and crises than actually will occur, but that doesn’t stop us from worrying just the same. Our concerns generally encompass what we’ve seen happen before, particularly what has happened more recently.
We Californians, for instance, weren’t so terribly concerned about fires five years ago. But having witnessed many devastating fires since then, we’re now more painfully aware of the risk of living here. Fires are now something we worry about and try to prepare for accordingly.
We expect, in other words, what happened last time or the time just before that – but risk is generally not where we anticipate. Take the citizens of Pompeii, who weren’t worried about Mount Vesuvius erupting in 79 AD. The volcano hadn’t erupted in almost 1,900 years, and so most, if not all of those living at its feet didn’t know it had ever erupted at all -- literate Greeks arrived in the area, which was inhabited by tribes that had no written language, only in the 8th century BC. So understandably, the Pompeiians failed to anticipate the risk that Vesuvius would erupt, and they paid for that blindness with their lives.
For the most part, we can only worry about what might erupt next if we know the horrors of a previous eruption or conflagration, and fortunately, we do have historical records and, for many of us, personal recollections of what happens when companies, governments and people take on a lot of debt.
And so leverage, particularly lower quality, burgeoning corporate debt, is the area we will focus on here because of such memories and history. We will consider both the absolute level of leverage as well as the probability that assets and earnings may be insufficient to fully meet current obligations.
Investors attempt to move forward using their rear view mirror for direction, giving more weight to what has happened than what might. A decade ago, the US consumer carried too much debt. At the same time, US and European banks suffered with too little equity to absorb the losses of poorly underwritten loans -- the left side of the balance sheet wasn’t right, and the right didn’t have much left. Overzealous homeowners and speculators, aided and abetted by shameless bankers, fostered and exacerbated the Great Financial Crisis of 2008/09.
At First Pacific Advisors (Trades, Portfolio), we avoid using the rear view mirror except when we intend to go in reverse. We prefer instead to look forward through our windshield, despite it being dusty and cracked.
We believe that sovereign and US municipal governments and corporates are more the problem now and that their excessive leverage will either catalyze or magnify the next downturn. The current debt trajectory, in terms of levels and quality of credit, is unsustainable and will inevitably end. Understanding this today will hopefully protect the capital of our investors in the future.
The average American today appears to be in relatively good financial shape. Household net worth in the United States is at a new high, and debt service payments as a percent of disposable income is at a four-decade low, as exhibited in the following graphs.
Net Worth of US Households1
Household Debt Service Payments as a Percent of Disposable Personal Income2
US households have slightly higher debt than the last recession (below left), but thanks largely to home price appreciation and, as pointed out above, their net worth is higher. Their stronger financial position, though, has been replaced by the weaker financial position of a more leveraged of Corporate America (below right).
While this has left the US consumer with a less onerous financial burden relative to income, “conservative” investment grade bonds have almost the most leverage in at least the last quarter century.
The other broken pillar in the Great Financial Crisis, the big US banks, also is in a much better financial position today, with more equity to support what we believe are better quality loans. The market cap-weighted average level of tangible equity to total assets of S&P 500 banks is 8.8%, up from 5.4% in 2008, while their non-performing loans have declined from 5.0% in 2008 to 1.1% as a percent of total loans during a similar period.5,6 This stands in stark contrast to the many European banks that have neither taken necessary loan write-downs nor built necessary equity. European banks have equity that is still only at 2008 US bank levels (5.4% in 2018 vs 3.7% in 2008), and the percentage of their loans that are non-performing is higher (3.7% in 2017 vs 2.8% in 2008).7,8
Additionally, the average nation now carries more debt than it has historically. Most significant countries as measured by size of economy sit at or above the 90th percentile of their historic debt-to-GDP ratio. More debt today means higher interest payments and less flexibility in the future.
To be sure, the increase in sovereign debt has aided global economic growth, but we believe it is unlikely to continue to boost economies in the same way it has in the recent past. Sovereigns will have their denouement, and in some cases, leaders may choose to inflate their way out of the debt strait jacket. At the very least, many countries may come to resemble the zombie corporations we address further on in this commentary and find their economic growth imperiled by an inability to increase already bloated debt levels and/or be forced to pay the higher financing costs that induce recession.
One does not have to look back any further than the recent travails of Greece. Higher borrowing costs and a deep recession led the market to realize that the country’s total debt burden, a combination of sovereign debt, pensions and so forth, was unsustainably high. This led to riots, political upheaval and, of course, declines in the price of Greek sovereign debt. Holders of Greek bonds (other than the European Central Bank) ultimately received mere cents on the dollar.
High levels of government debt in the US is not a federal issue alone. State and local governments are weighed down by huge debt loads and unfunded pension liabilities. Meredith Whitney conducted thoughtful municipal research in 2010, lamenting the sad state of municipal affairs and anticipating widespread municipal bankruptcies.10 When asked why people seemed oblivious to the problem in a 60 Minutes interview, she responded, “Because they don’t pay attention until they have to.”11 We appreciated the problem then as we appreciate the current problem, but just as before, we have no ability to ascertain timing, thanks to changing tax policies and the long-term nature of off-balance sheet liabilities like pension obligations, infrastructure spending and the like. Nevertheless, horribly weak balance sheets at the state and local level, depicted in the chart below, may ultimately become manifest in the form of additional Chapter 9 bankruptcy filings at the municipal level.
As we said, the question of timing eludes us (again), and we appreciate that merely pointing out challenges that might face us due to excessive government leverage is an exercise in incompleteness. Sometimes, though, mentioning an issue piques a reader’s interest and fosters additional consideration.
Our aptitude squares better with corporate debt, and thus corporate debt is the focus of this piece.
The sum of US corporate bonds outstanding totaled $3.8 trillion in 2008 and has since more than doubled to the current $8.8 trillion.13 This 8.8% annual rate of increase is more than two times GDP growth in that same period. The increase has aided corporate mergers and acquisitions (“M&A”), leveraged buyouts and share repurchases and supported to some immeasurable level the growth in corporate earnings, all of which have served as drivers of US stock market returns. But we think it’s safe to say at this point that there won’t be the same continuing demand for corporate debt to provide the same stimulus in the future.
Corporate debt is now at an all-time high as a percent of gross domestic product.
Corporate debt cannot continue to grow faster than the economy forever, and when it slows, the more recent strength in the economy and stock market will lose a significant engine of growth.
This begs a moment to reflect on the drivers of corporate debt growth.
Banks curtailed lending after the Great Financial Crisis of 2008/09, and rumblings about the fragility of our banking system continue in some quarters today still. We believe those are backward looking fears. The large US banks have, on average, better balance sheets than a decade ago, meaning more conservative loan portfolios supported by more equity. Yet stricter underwriting by banks and a reduced willingness to lend created a credit void in the market.
Wall Street, always happy to create and sell products, stepped in to fill the gap with passive and active mutual funds, partnerships and various structured vehicles. The addition of debt to many of these portfolios allowed for the supply to meet escalating demand. It can be a match made in heaven or hell when an enthusiastic seller finds an agreeable buyer, and there have been plenty of those. Who doesn’t like (almost) free money?
Low base interest rates and a narrow spread to a risk-free rate has led companies to refinance and add new debt with a much lower hurdle rate, which allows for near-term accretive activities like M&A, share repurchases and so forth. But the longer term is something else entirely, as a company’s ability to satisfy its existing debt obligations may eventually be challenged by a recession due to weaker cash flow and more circumspect lenders who require a higher coupon rate to justify the perceived risk. And, of course, the base level of interest rates might not be so low as it has been.
Corporate bonds can be segmented into two broad categories: High-yield and levered loans and investment grade. While, high-yield bonds and levered loans outstanding grew from $1.3 trillion to almost $2.4 trillion, the investment grade debt market almost tripled from $2.5 trillion to $6.4 trillion.16
High-yield bonds, which are a reasonable proxy for levered loans, now offer a prospective return to maturity of just 7.2%.17 In our view, that’s still an unattractive yield for the risk assumed – and it’s a gross yield, before any defaults. If one were to consider the yield following some inevitable level of defaults, the net yield will be lower. We can debate what defaults will be, but defaults have not been, and most likely never will be, zero. Using historic default rates as a rough proxy for illustrative purposes, the net yield on US high-yield bonds drops dramatically, to just 5.1%. It stands to reason that the longest economic expansion in history has bred some degree of complacency among borrowers and lenders and that future defaults may climb above the average before too long.
US junk bond yields fall in line with investment grade bond yields, begging the question, Why bother?
The prospective net yield of high-yield European bonds is just 1.7%20, far lower than even that of US bonds. Such unjustifiably low yields are a function of a lower European base interest rate and the European Central Bank’s (ECB) market-manipulating purchase of slightly more than 20% of eligible corporate bonds in the last couple of years – €174 billion purchased of €850 billion eligible.21 We call this government-managed capitalism.
The US and EU are not alone. Other parts of the world also have their fair share of weak corporate credits, as pointed out in a 2018 McKinsey report.22
Economic cycles will not be subverted – despite the best efforts of central bankers – and there will again be defaults, quite possibly with a lower recovery in bankruptcy, with only the magnitude up for argument.
We strongly feel that the high-yield bond market’s net yield does not justify the risk. And we haven’t touched on the rise in leverage yet. Some might call that prospective yield “return free risk.”
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