The Wall Street Journal quotes Christina Padgett, head of leveraged finance research at Moody’s Investors Service Who said: “Leverage is getting back to where it was pre-crisis. After the crisis, companies were behaving more conservatively and lowering their debt.”
Feels like the Last Time (but not quite as bad)
We have reported on companies which issued bonds and stock to pay off loans, only to take out more loans, leaving the new bonds and diluted stock outstanding. Investors desperate for yield have been all too eager to purchase corporate loan securities from investment companies promising high yields and relatively low default rates based on… (wait for it) historical models. Here is the truth folks: Corporate defaults have plummeted because corporations which could have/should have defaulted have been kept alive by leverage provided by yield hungry investors. Call it what you will, a virtuous cycle, and positive feedback loop or a self-fulfilling prophecy, but junk loans have “worked out” thus far because of investors’ thirst for yield. Once this thirst is quenched or satisfied by higher yields among higher-rated investments, many of these businesses could find themselves with insufficient revenue and a lack of credit to remain afloat. Bankruptcies and/or corporate debt restructures could result.
We do not mean to beat a dead horse, but with the mainstream financial media finally discussing what we have seen coming for more than a year, we must make note of this.
The Fed’s low-rate policy is designed to encourage investors to provide capital to businesses, but as yields fell throughout the credit markets, investors reached deeper and deeper into junk. We have listened to actual sales pitches and received actual marketing materials from purveyors of leveraged loan products. We did all we could to keep from laughing. If not out of respect for our colleagues who have productive relationships with these firms in other areas of the markets, we probably would have put some of these sales reps through the wringer.
The following passage from the Journal really hits home: “Many companies are repeating some of the mistakes of the past,” by taking on too much debt, said Edward Altman, a New York University business school professor and the creator of a well-known tool for measuring corporate health, called the Z-score. “
“Mr. Altman said his latest forecast, which measures the probability of corporate defaults, showed overall corporate health was “no better than it was in 2007 and by some measures worse.” The median scores, which measure corporate financial health by analyzing a combination of liquidity, earnings, solvency and stock market valuations, were 4% lower for companies rated “junk” in 2012 than in 2007.”
Believe the pie in the sky stories of high yield, manageable risk and a decoupling with rates at your own risk, but remember, as the bond market renormalizes, so do corporate default rates. Remember where you heard it first, last year.
And now for something completely different
The counterpoint to the risk bubbling up in junk debt is that creditworthy corporations have been able to not only issue new debt and more debt, but longer-dated debt. We don’t blame them. A corporate treasurer would have to be daft not to lock in today’s rates (or last spring’s rates) for as long as they can. The U.S. government should have issued more long-dated debt as a percentage of its total debt issuance.
What is of concern to us that corporate debt has been rising more quickly than corporate profits. According to Moody’s the rate of corporate profit growth has fallen from 39% in 2010 to 8% in 2012. Corporate profits grew at 3.9% in the first half of 2013, according to Moody’s. Blue chip companies, such as JPM or GE can probably service higher debt levels should profit growth continue to slow and would have little difficulty tapping the debt markets when the need to refinance maturing debt arises. CCC and CC-rated companies might discover that their access to credit is prohibitively expensive, if it is available at all in the near future, which could force bankruptcies or debt restructurings.
As we have stated before, interest rate renormalization probably means corporate default renormalization. That leaves debt (both loans and bonds) issued by junk-rated companies at an increased risk of default.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NYThomas Byrne
Director of Fixed Income
Wealth Strategies & Management LLC
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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