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Thomas Macpherson
Thomas Macpherson
Articles (169)  | Author's Website |

The Changing Face of Debt

For investors, a simple US Core Bond Index fund looks nothing like it did in 2008. The changes in the type and quality of debt require some significant research by investors

August 20, 2019 | About:

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 man’s 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 world’s 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, it’s 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 man’s credit is as good as his money. Regardless of how secure you think debt may be, it’s 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. government’s 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 doesn’t assure you a positive return. Much the same as purchasing a stock, an investor should spend a considerable amount of time studying the company’s 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.

Conclusions

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. It’s rare to hear individual or institutional value investors discuss the purchase of individual bonds. Because of that, it’s 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.

Disclosures: None.

Read more here:

Market Volatility: A Time for Testing

Advisor's Alpha: Vanguard's Model

An Agonizing Reappraisal

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 4.9/5 (9 votes)

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Comments

stephenbaker
Stephenbaker - 3 weeks ago    Report SPAM

Very good article, Tom. I would also question the consistency of bond rating agencies and whether a BBB rating today is in fact less safe than a BBB rating 10 years ago. The reality of today's negative worldwide interest rates (and even some negative mortage rates) are really hard to get a handle on. I just can't make any sense out of this. Naive question: Why would anyone (individual, business entity, sovereign entity) purchase debt at negative yields when higher rated US treasuries are available for purchase at a positive yield?

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi Stephen. We are having a tough time making sense of it too. Our feeling at Nintai is bolt everything down, be as conservative as possible, and prepare for the worst. We’ve only been this unsure once before and that was in 2007. Thanks for your comment. - Tom

Praveen Chawla
Praveen Chawla premium member - 3 weeks ago

Great thoughts and well written. BBB debt is likely not much safer than equity of well run companies. No wonder stocks of perceived safe companies like P&G has skyrocketed as investors realize that P&G equity is safer than the "near junk" bonds.

stephenbaker
Stephenbaker - 3 weeks ago    Report SPAM

Can a no interest or negative interest rate bond go into default prior to maturity?

sipdream
Sipdream premium member - 3 weeks ago

Even it may seem counterintuitive at first intuition, as a european investor i believe various European entities and individuals purchase european government bonds with negative yield, mostly because of: 1) lack of trust on banks, even the largest in Europe due to risk of bail-in if things precipitate (current and savings accounts are only protected up to 100K EUR each per person per bank); 2) Europeans envision a total bond-return in EUR and not in USD, so usually they do not purchase USD-denominated bonds, not even AAA because of currency conversion uncertainity (especially when several investment banks and politicians keep repeating that EUR is 25% undervalued vs the USD...); 3) European individual investors are much less financially prepared or educated, and there is a multi-generational culture based on the perception (backed by several past cases) that government bonds are "safer" (lower risk or partial or permanent loss of capital) than Corporate bonds - they also know Corporate AAA ratings sometimes may go to junk level in matter of days.... resembles 2008?), while this is usually not happening with government bonds, or at least not so fast (or at least didn't happen so far....).

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi everyone. Thanks for your comments. As for a negative yield bond, I see no reason why it couldn’t be defaulted on. If the base business can no longer meet its debt obligations, the company will default negative yield or not. We sure are living in interesting times. Thanks for all your wonderful comments. Always great to learn from the community. Best - Tom

briankahoyu
Briankahoyu premium member - 3 weeks ago

Hi Mr. Thomas,

Great articles as always. From what I understand, the total debt to GDP or equity ratio has been consistently increasing over the past decade. This isn't just happening to America - this is happening all over the world in basically every single country except for a small few.

I am trying to understand why this is happening - isn't this a concern? And not to mention, as you insightfully pointed out, the quality of the bonds within the average investor's mix has also dropped.

I am not sure why leverage world wide is increasing especially, given the lowered quality debt mix too. It's only a matter of time when deleveraging becomes inevitable.

Thomas Macpherson
Thomas Macpherson premium member - 3 weeks ago

Hi Brian. Thanks for your comment. The growth of debt - whether it be personal/individual, corporate debt, or sovereign debt - the issue always becomes one of servicing such debt. Some debt is easier to keep afloat (soverign entities can increase taxes in most cases) than other. But the total amount is concerning. In addition - to your point - the quality of the debt and the structure of it is more concerning to me. We learned in 2008 that relationships between debt issuers, creditors, covenants, and debt agreements (such as credit default swaps) created connections nobody considered. While each crash is unique in its own way (to badly paraphrase Dostoevsky), as Andrew Ross Sorkin writes, too much leverage is a common theme. DISCLOSURE: Brian's family is an investment partner in Nintai Investments LLC.

stephenbaker
Stephenbaker - 3 weeks ago    Report SPAM

Sipdream, I appreciate your comments. Following up, why would Europeans invest in negative yielding bonds when they could simply store Euros, particularly if they believe the currency is undervalued? I am still trying to make sense of this. If my currency was undervalued and the only available investment option was to pay an issuer to retain my principal, a shovel is all I'd need to dig a large hole in an inconspicuous place. On a more realistic note, I just don't understand why anyone would believe that the safest investment option available in the entire world is negative yielding debt. (Selfishly, there are certainly ways for more rational-thinking folks to benefit from such hysteria.)

cbourbs
Cbourbs premium member - 2 weeks ago

https://www.youtube.com/channel/UCBH5VZE_Y4F3CMcPIzPEB5A

Watch this youtube channel. I have been binge watching it over the last couple weeks. It explains the macro issues that the world is facing right now. If the U.S. dollar continues to increase it will be hard for overseas U.S. denominated debt to get repaid. As the world begins to feel this pressure people will flock to U.S. dollars. This will create a reinforcing cycle. The Feds will have to bring interest rates to zero and start QE to devalue the dollar. Also as Thomas points out the if the BBB debt gets downgraded to junk, pension funds will offload these bonds and crash the junk bond market. With no one to buy the bonds lots of highly levered companies will go bankrupt. This will force the feds to back government and private pension funds....could be some scary times ahead.

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