Allocation Strategy During The Corporate Debt Hangover

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Includes: BND, IEF, IEI, QUAL, SHM, TFI, USMV
by: Gary Gordon

Summary

Total leverage by U.S. 'investment grade' corporations has catapulted through the proverbial roof.

If one shifts to corporations on the world stage, the picture becomes more nebulous.

So how might one invest in an environment where corporate and government debts have skyrocketed, asset prices have hit extremes and the Federal Reserve is committed to raising borrowing costs?

Are corporations in great shape? Three consecutive quarters of declines in earnings suggest that they are not. Worse yet, record high leverage coupled with close-to-record low interest coverage indicate stress within corporate balance sheets.

Beginning with the “profit recession,” it has become fashionable to describe the deterioration as a function of the price collapse in oil and gas. However, that assessment fails the sniff test on three different levels. One, six of the ten S&P 500 economic segments share in the year-over-year earnings contraction, not the energy sector alone. Second, if one excludes energy as an outlier on the negative side, one would be obliged to throw away super-sized contributors like healthcare on the positive side of the ledger. In doing so, the profit picture still appears weak.

A third reason that it is foolish to dismiss energy earnings? Analysts made the same mistakes prior to the economic downturns in 2001 and 2008. It was short-sighted to toss the technology sector in the dot-com collapse. It was irrational to exclude financials in the banking crisis. It follows that it would be just as insular to ignore the influential energy segment when evaluating corporate profitability today.

Earnings Recession

Perhaps more troubling is the erroneous belief that corporations have improved their balance sheets since the Great Recession. In truth, U.S. companies have doubled their total debt levels since 2007, while simultaneously finding it more difficult to pay interest expenses on outstanding obligations.

According to Investopedia, the interest coverage ratio determines the ease or difficulty by which a company can service its existing debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBITA) by the company’s interest expenses for the same period. The higher the ratio, the less burdened by borrowing costs a company is; the lower the ratio, the more onerous the debt expense is for a company.

Now take a look at the charts below. Total leverage by U.S. “investment grade” (IG) corporations has catapulted through the proverbial roof. Leverage does not matter as long as companies can service the debt, right? Unfortunately, investment grade interest coverage is back to levels not seen since 2009.

Coverage

If one shifts to corporations on the world stage, the picture becomes more nebulous. Consider the net debt-to-earnings (EBITA) at global companies. This measure looks at the number of years, theoretically speaking, that a company would require to pay obligations back. And right now, according to Standard & Poor’s, net debt-to-EBITA in 2015 at 3.0 was the highest since 2003.

That’s not all. Analysts typically regard a ratio below three as “safe.” With the average global company straddling the fence between safe and not-so-safe, what does that tell investors about the financial health of the world’s corporations?

Debt TO Earnings Ratio

Why should anyone focus on all the debt talk surrounding the world’s corporations? Don’t they always find a way to right their respective ships? Well, for one thing, if a company has money left over after it services its debt obligations, it cannot necessarily expand its business in productive ways, including research, development, human resources acquisition, marketing and so forth. We’ve already seen the most recent reading of the Institute For Supply Management (ISM) Non-Manufacturing Index hit its lowest level since March of 2014 (55.3). That’s not encouraging, even if it shows expansion in the services arena.

In a similar vein, it is highly discouraging to witness carnage in the capital goods arena. It would seem that companies are unwilling and/or do not have the discretionary dollars to invest in tangible assets to produce goods or services such as office buildings, equipment and machinery. Maybe debt is taking a nasty toll after all. (See the chart below.)

Non Defense Cap Goods

So how might one invest in an environment where corporate and government debts have skyrocketed, asset prices have hit extremes and the Federal Reserve is committed to raising borrowing costs? Former PIMCO “guru” Mohamed El-Arian has finally decided that 25%-30% in cash is the best way to survive what he anticipates will be better buying opportunities down the pathway.

For my clients at Pacific Park Financial, Inc., we began making the tactical allocation shift in June of 2015 – seven months ago. We downshifted from 70% growth (e.g., large-cap, smaller-cap, foreign, etc.) to roughly 50% growth (high-quality, low volatility large-cap stocks). We moved from 30% income (e.g., short, long, investment grade, higher-yielding, etc.) to approximately 20%-25% investment grade income. With cash or cash equivalents approximating 25% – safer harbors such as the SPDR Nuveen Barclays Short-Term Municipal Bond ETF (NYSEARCA:SHM) as well as money market vehicles – we reduced volatility while awaiting better buying opportunities.

While I expect the corrective activity that began in May of 2015 to continue, my clients understand that I seek to reduce risk, not eliminate it. It follows that current stock exposure at 45%-50% does not represent a mindset of “shorting” or being out of equities completely. For the most part, we have been out of foreign positions and smaller U.S. companies for quite some time. Nevertheless, we maintain an allocation to equity ETFs via funds like the iShares MSCI USA Quality Factor ETF (NYSEARCA:QUAL) and iShares USA Minimum Volatility ETF (NYSEARCA:USMV).

The bond story is remarkably similar. Rather than pursue cross-over corporates or high-yield or even long-term investment grade corporates, we have stayed near the middle of the curve with funds like: (1) the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA:TFI), (2) the Vanguard Total Bond Market ETF (NYSEARCA:BND), (3) the iShares 7-10 Year Treasury Bond ETF (IEF) and (4) the iShares 3-7 Year Treasury Bond ETF (NYSEARCA:IEI).

There are those who crave a bit more potential than cash or T-bills. For those folks, rather than “shorting,” we employ multi-asset stock hedging. We’ve picked up some of the assets in the FTSE Multi-Asset Stock Hedge Index, including the yen, gold, and zero-coupon treasuries.

Make no mistake about it, however. The cash that had been raised in 2015 has multiple purposes. It provides a measure of comfort when stock volatility surpasses norms. In addition, cash offers one the ability to acquire “buy low” value propositions. Even now, there are folks with excess cash who might want to examine a dividend aristocrat like Aflac (NYSE:AFL). With a trailing P/E of 10, a forward P/E of 9, a dividend yield of 2.9% and a price from mid-2014, you may decide the rewards are worthy of the risk.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships