Debt, we've learned, is the match that lights the fire of every crisis. Every crisis has its own set of villains - pick your favorite: bankers, regulators, central bankers, politicians, overzealous consumers, credit rating agencies - but all require one similar ingredient to create a true crisis: too much leverage.
- Andrew Ross Sorkin
No mans credit is as good as his money. - John Dewey
Early this summer I wrote about debt and the Russell 2000 (Where Are the Prisoners? Debt and the Russell 2000.") In the article I discussed two salient points made by Stanley Druckenmiller (Trades, Portfolio). First, debt in the Russell 2000 has been growing far faster than profits (debt grew by 65% from 2010 to 2018 while profits grew by 29% in the same period). Second, between 2010 and 2018, stock buybacks ($5.7 trillion) far exceeded capital expenditures ($2.2 trillion). This is a complete reversal of the last 35 years, which averaged 20% buybacks versus 80% capex. I also wrote about the changing structure of corporate debt in Fata Morgana and the Illusion of Safety. In that article, I wrote about the explosion in covenant-lite loans (essentially debt requiring little or no collateral as well as little to no documentation) from less than 5% of total leveraged loans to roughly 75% today.
I bring this up again because a great discussion took place at the Morningstar Investment Conference earlier this year in Chicago. In a summary and transcript of a panel conversation (Rates, Spreads, and Credits, Morningstar Magazine, Fall 2019, page 56), experts discussed the changes in both the debt being issued as well as the form it is being invested in by the markets. Combined with my earlier discussion, I think it is wise for all investors institutional or individual to take a closer look at how it might impact both the overall markets, individual portfolios and sovereign economies.
The Changing Face of Debt
We know that each new financial crisis is a pale cousin of the last, although as Andrew Ross Sorkin wisely stated there is almost always a component based on leverage and excessive debt in the mix. Looking out over the debt markets, it seems some of the novel products or the move to passive indexing has completely upended the debt markets over the past two decades.
Credit Standards have Dropped to Alarming Levels
At the Morningstar conference, it was pointed out that roughly half of all corporate debt is made up of BBB-rated quality (one notch above junk status). According to Morningstar, the composition of a U.S. Core Bond Index fund has seen its credit quality drop from A in 2008 to A- in 2018. BBB credits as a percent of corporate market value (meaning what percent of total corporate debt) have risen from 27.8% in 2008 to 48.9% at year-end 2018. Additionally, (and perhaps more frighteningly) the percentage of BBB credits that makes up the total market value of the index has risen from 9.2% in 2008 to 19.1% at year-end 2018. This means that the individual investor has seen their typical core bond index fund double its share of BBB credits just one notch short of junk status double over the last decade. One can only imagine what type of returns an investor might see should we find ourselves in a 2007 to 2009 credit crisis again.
What We Mean by Core Has Changed A Lot
In 2008, government debt made up roughly 31% of a core index bond fund. By year-end 2018, that number had increased to 42%. A real change was agency debt. This dropped from 7.5% in 2008 to just 1.3% in 2018. The largest change in percentages and dollars was the decrease in mortgage-backed securities. This was the debt that played the critical role in the U.S. housing market bubble and the subsequent crash. It went from 43% of the U.S. core bond index in 2008 to just 29% at year-end 2018. All of these changes have fundamentally changed what investors have in their portfolios when they invest in a core bond index fund. Combined with the changes discussed earlier in corporate credit quality, investors are looking at a substantially riskier product.
Rates are Increasingly Volatile in Nature
Since writing my articles about corporate debt roughly five months ago, we have seen some extraordinary changes in the bond markets. The U.S. Treasury yield curve has inverted, the China-U.S. trade conflict has moved closer to a trade war, the President of the U.S. is threatening the chairman of the Federal Reserve and calling him clueless, and over $15 trillion (with a T) of global sovereign debt has a negative yield. We also see the U.K. careening towards a completely Wild West Brexit, several of the worlds largest economies teetering on the edge of recession and Hong Kong simmering on the brink of revolt against mainland China oversight. Navigating these waters and finding security in the bond markets is becoming increasingly hazardous.
Passive Indexing has Affected Bond Market Liquidity
The ability to connect a buyer and seller (or market liquidity) even during times of market difficulties is essential to maintaining asset prices. When liquidity breaks down, investors can begin to see distortions in pricing. Until 2008, the largest bond brokers warehoused bonds, assuring there was adequate liquidity and seamless trading in the debt markets. By 2018, that had changed to the point that the markets no longer resemble that model at all. For instance, in 2007, there was roughly $7 trillion in outstanding corporate debt. Dealer inventories were roughly $250 billion. At year-end 2018, there was roughly $10 trillion in outstanding corporate debt (an increase of 43% between 2007 and 2018), but dealer inventories had dropped to $12 billion (a decrease of 95% between 2007 and 2018). This collapse in inventories will create an enormous crimp on liquidity should we face another credit crisis similar to 2007 to 2008.
What This Means
For individual or institutional value investors managing portfolios heavily tilted to equities, this whole conversation about the evolution of the debt markets may seem beyond their interest or investment scope. I would hasten to remind portfolio managers who saw no connection between mortgage-backed securities and the S&P 500 index to reflect back on those halcyon days of late 2007 through 2008 when most major stock indexes dropped 35-40%. The bond markets act as the lungs to the greater asset markets ranging from equity indexes to venture capital. When the lungs stop breathing, its safe to say it catches most people's attention. It has in every other crisis, and the next will be no different.
As an institutional investor, I have a fiduciary responsibility to my investment partners to prevent the permanent impairment of their capital. Whether that is a portfolio made up of 95% equities with a 100-year time horizon, or one with 90% bonds paying for a planned 15-year retirement, the bond (and credit) markets can make and break returns. Bearing that in mind, here are a few rules that I try to live by in this wildly fluctuating market.
Cash is Still King
As John Dewey pointed out, no mans credit is as good as his money. Regardless of how secure you think debt may be, its still not better than cash. Even U.S. Treasuries considered the safest investment in the world can be dramatically impacted when the president of the U.S. suggests we could simply renegotiate our debt at will. It also could also equally be affected by Congress simply not increasing the U.S. governments credit limit. While running from the risk of inflation or lost opportunity costs, the holding of cash is sometimes the best of a bad lot.
Debt is Never Stagnant in Price or Value
Unless the investor intends to purchase debt at par and hold for its duration, or until it is called (while still running the risk of default), the pressures of inflation, the Federal funds rate, currency exchange, and so forth, can make bonds surprisingly fluid in their valuations. As one looks at the changes in a U.S. core bond index fund, you can see dramatic changes in risk and uncertainty in just the past 10 years. Always remember that bond pricing and valuation is not stagnant. One can overpay or suffer permanent capital impairment in bonds just as easily as equities.
Valuation and Risk Assessment is Vital
Just as a good value investor will look at the act of equity investing as purchasing a part of a business, investing in debt is no different. Though you might be higher on the bankruptcy totem pole, this doesnt assure you a positive return. Much the same as purchasing a stock, an investor should spend a considerable amount of time studying the companys financial statements, competition, markets and so forth. I should point out that significant focus should be on the ability of the company to meet current and future debt servicing requirements.
The debt markets are a foreign concept to many value investors. For many, a simple bond index fund or exchange-traded fund will take care of any bond coverage they feel they need. Its rare to hear individual or institutional value investors discuss the purchase of individual bonds. Because of that, its even more important to understand the general debt markets, their trends, their risks and what story they are telling us at the moment.
At Nintai we have an almost unhealthy focus on risk mitigation. Every day we ask what market data can warn us of risk and uncertainty in the markets. Right now the debt markets are telling us that markets are in general overpriced, the risk of both a U.S. and global slowdown is higher than is appreciated, and cheap debt is at risk of rate fluctuation or slowing growth. Those messages taken in context with our portfolio positioning mean we are prudent in our assessment of debt carried by our holding companies, ruthless in credit quality requirements and maintain large cash positions.
As always I look forward to your thoughts and comments.
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