Watch That Corporate Leverage, Folks

| About: SPDR S&P (SPY)

Summary

Have you paid attention to the S&P's interest coverage recently?

Well, perhaps you should.

You should probably also take a good hard look at CCCs.

On Tuesday, I was sipping some Tanqueray with a splash of olive juice trying to fish out the blue cheese-stuffed olive that for some reason didn't come skewered on a cocktail spear, when I noticed one of those commercials you usually see late at night on TV.

"Do you owe more than $20,000 in debt?" some solemn voice in the background will begin.

"Are you having difficulty paying the bills?" he'll continue.

"Does your current income just not cut it?"

"Then call the debt experts today."

And then there's usually a big yellow or red number at the bottom of the screen. The only more ominous sounding commercials are the ones that begin with something like "did you or a loved one take XYZ for blood pressure only to subsequently have a stroke?"

What's funny to me is that no one takes the same approach to the debt of the corporations they invest in like they do their own finances even though those corporations are part of their finances.

No one stays up at night worried about how one of the major holdings in their portfolio is going to service its debt (unless you are a major, major player).

Let me show you what I mean. I posted the following picture elsewhere which demonstrates the extent to which the S&P 500's (NYSEARCA:SPY) interest coverage has declined nearly to crisis levels across market cap classifications:

Click to enlarge

(Chart: SocGen)

That's not exactly what you want to see and speaks to the very same point I've been making for I'm not even sure how long now. Namely, that companies are taking on too much debt to please shareholders with dividends and share buybacks which simultaneously inflates the bottom line (artificially of course).

As Goldman noted earlier this year, there is no net demand for US equities this year outside of the corporate bid.

Here's another look the chart above, only turned on its head:

Click to enlarge

(Chart: Barclays)

See that? This is headed in the wrong direction as companies lever up. Here's a bit of commentary from Barclays (emphasis mine):

...median ratio of debt-to-EBITDA for companies in the S&P 500 (excluding financials) was just 1.53x in 2010. Now it stands at 2.33x, the highest point in at least 20 years. The total ratio of debt-to-EBITDA for the S&P 500 (rather than the median ratio) has reached 2.56x, excluding financials. And the increase has not just been caused by the Energy sector. If Energy is excluded in addition to Financials, the total debt-to-EBITDA ratio is 2.50x and it too has been rising rapidly.

This is what you're paying 17X+ for folks.

Let's focus on one of my favorite topics in this debate: high yield credit (NYSEARCA:HYG). You know, my Labradors. If you're not familiar with the liquidity problems in the HY ETF space, I strongly encourage you to read here, among other articles on the subject. Even Virtu - the HFT firm that as of its S-1 had only had one losing day in half a decade - won't trade the HY ETFs because they can't access the underlying bonds fast enough to hedge and then arb the trades.

The worry is always this: What happens when everyone wants to sell their HY ETFs? Where is the redemption money going to come from if Wall Street won't inventory the bonds? There's no answer for that question. But what we do have is some rather disturbing commentary out of Deutsche Bank about assumed defaults in the CCC space. Have a look (emphasis mine):

Figure 1 plots the proportion of CCC issuers who have not accessed the primary market in at least three years. About 42% of non-commodity CCCs have not placed a new bond deal for this long, a higher proportion than at any point in this credit cycle.

The other indicator we present in Figure 2 is the proportion of CCC names with meaningfully inverted CCC curves, defined as 300bps or greater between 2..3yr and 6..7yr bonds.

The end result is that 43% of ex-commodity CCCs that have both 2..3yr and 6..7yr bonds outstanding today are trading with substantially inverted spread curves, a time-proven sign of credit concerns. It is also remarkable to see these multifaceted indicators of stress -proportion of 1000+ spread names, proportion of non-financeable names, and proportion of names with inverted curves being so close to each other -at 37%, 41%, and 43% respectively.

Click to enlarge

(Chart: Deutsche Bank)

So this is the kind of commentary coming out of the Street. And you think these are the guys that are going to step in and buy junk bonds from your fund manager so you can have your money back when you want to sell in a pinch?

Get ready to hear a new kind of commercial at 2 am in the morning. It will start something like this:

"Have you or a loved one gotten stuck with shares of junk bond ETFs you don't want? You may be entitled to a settlement..."

Ha! Finally got my olive out.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.