Risk is where you are not looking

By Steven Romick

This article is an extract created by Nedgroup Investments from a much more detailed paper from FPA, which you can read here.

Investors typically 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, 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.

What are we seeing ahead?

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 and understanding this today will hopefully protect the capital of our investors in the future.

“Conservative” investment grade bonds today have almost the most leverage in at least the last quarter century. 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 “zombie corporations” 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.

The question of timing, however, 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.

US corporate debt now at an all-time high

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.[1] 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.

Steve Romick Q2 2019 1

US corporate debt is now at an all-time high as a percent of gross domestic product. However, it 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.

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 as low as it has been.

High-yield bonds, which are a reasonable proxy for levered loans, now offer a prospective return to maturity of just 7.2%.[3] 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.

Steve Roick Q2 2019 2

The prospective net yield of high-yield European bonds is just 1.7%[5], 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. 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.[6]

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. Some might call that prospective yield “return free risk.”

Conclusion

Some people choose to live in zones which have high risk of fires and volcanic eruptions without understanding the risk, while others understand the risk yet live there anyway. We believe many investors in the bond market are living with risk they don’t appreciate. Therefore, they lack appropriate consideration for what might happen. At some point we expect fear will re-enter the market, and we are prepared to follow on its heels to scoop up attractive opportunities.

These thoughts communicated here are not new but given the continued stretching of the proverbial rubber band, we thought it prudent to spend this time communicating our concern with the world. Fears of a recession have led to corporate bond market weakness in Q4 2018, and with the commensurate increase in lender caution, we are beginning to see investment grade borrowing costs increase.

We cannot and never do speak to timing. This may all be a head fake at this moment in time. That, however, does not change the real risk that remains – a risk that someday may be realized.

Michael Lewis discusses unappreciated threats in his new book, The Fifth Risk. Although he isn’t speaking about investing, one of his thoughts seems a fitting way to close. “If your ambition is to maximise short-term gain without regard to the long-term cost, you are better off not knowing the cost.”

On the contrary, we seek to maximize long-term gain while knowing the costs, willing as always to sacrifice the near-term in its pursuit.

 

[1] Bloomberg, J.P. Morgan. As of November 30, 2018.

[2] Bloomberg, J.P. Morgan. As of November 30, 2018. US corporate debt market is represented by sum of the face values of investment grade corporate bonds within the ICE BofAML US Corporate Bond Index (C0A0), high yield bonds within the ICE BofAML US High Yield Master Index II (H0A0), and levered loans as reported by JP Morgan. 

[3] Bloomberg. YTM of the BofA Merrill Lynch High Yield Master Index II (H0A0)

[4] US gross yield as of November 30, 2018: BofA Merrill Lynch High Yield Master Index II (H0A0); U.S. historical high yield default and recovery rates: J.P. Morgan, Moody’s Investors Service, S&P LCD using year-end data from 1982-2018 Q3; EU gross yield as of November 30, 2018: BofA Merrill Lynch Euro High Yield Index; EU historical default rate: J.P. Morgan Europe Guide to the Markets (12/31/2017); EU historical high yield recovery rate: Moody’s Investors Service using 1985-Q3 2016 data. Net Default Rate = (1 - recovery rate) x default rate. Net Yield = Gross Yield minus Net Default Rate. Note: The Moody’s EU High Yield (“HY”) recovery rate at Q3 2016 was approximately 2.6%. The Moody’s EU HY recovery rate has remained relatively unchanged for the period Q3 2016 through Q4 2017 and Q3 2016 through Q2 2018, where the Moody’s EU HY recovery rate was approximately 2.7% and 2.3% at 12/31/2017 and 6/30/2018, respectively. (Source: Standard & Poor’s, Moody’s, and Association for Financial Markets in Europe (AFME) European High Yield & Leveraged Loan Report – European Leveraged Finance dated Q4 2017 and Q2 2018). We believe the impact of the changes in the monthly Moody’s EU HY recovery rate for the period Q3 2016 to Q1 2017 and for the period Q3 2016 to Q2 2018 on the overall average historical recovery rate over the period 1985-Q2 2018 will likely be minimal.

[5] See footnote 4 above

[6] McKinsey Global Institute, Rising Corporate Debt: Peril or Promise? Dobbs, Goldshtein, Lund, Windhagen, and Woetzel. June 2018.