Discussions about the most overvalued assets involve either equities, or Bitcoin. Sometimes maybe both. However, it seems that these two hot topics overshadowed the elephant in the room - debt levels and the upcoming increase in interest rates.
Data suggests that over the last few decades duration of corporate debt in the US has increased dramatically. At the same time, debt servicing ratios did not change by much. Also, the total amount of debt increased severely. All of these factors combined may have disastrous consequences, especially when FED tightens monetary policy, as described by yours truly.
Due to that investors should be very wary of holding corporate debt, especially long term, in their portfolios.
FED funds down, duration up!
As we all know, given normal market conditions, longer duration implies larger yield. Thus historically, long maturities were rarely seen in the corporate bond market. Companies would rather issue debt for a certain project and pay the money back or refinance that debt cheaper at the end of the term. Expectations to refinance cheaper were rational while for the last 35 years interest rates have been going down:
Twenty seven years ago average duration of investment grade corporate bonds was somewhere under 5 years. Back then, according to St. Louis Fed, average yield for 5 year corporate bonds was 9.5 percent. However, over those 27 years things changed and the average duration of investment grade corporate bonds almost doubled, reaching record highs:
Source: Tallus Capital Management
While, as the interest rates went down, the average yield decreased to 2.5 percent and total debt issuance rose almost six-fold:
Source: Tallus Capital Management
Cheap money and easy financing conditions induced companies to issue more debt with longer maturities. Everyone got used to ever decreasing interest rates and yield hungry investors. However, as monetary policy changes, the corporate debt market will change too.
Some basic math
Applying simple bond math, if 17 years ago 1 percent increase in FED fund rates would have meant approximately 27.5 billion of nominal losses in investment grade corporate market, today the same hike from the FED would lead to 127 billion in nominal losses - that corresponds to 0.7 percent of GDP.
Given the fact that the FED intends to raise interest rates 3 to 4 times next year, one may expect that someone will incur these losses in 2018. Be it corporations or investors, someone will have to pay. And that 0.7 percent of GDP gone will definitely have a negative effect on both financial markets and the real economy.
It might not look that scary from the macro point of view. The sole 0.7 percent negative effect on GDP in the period of growth does not look that bad. But how bad it gets depends on how monetary policy normalization actually plays out in general.
Not only 127 billion in nominal value of corporate debt holders could be wiped out. In addition, disposable income of households will decrease as FED funds go up and federal outlays for interest payments increase. Meaning a further collective negative impact on investment, consumption, GDP and macro overall.
On the other hand, if growth is sufficient, all of these might have just a minor effect. Especially given the incoming tax cuts. Thus currently one might only guess the magnitude of the impact that climbing yields will have on macro.
Leaving macro aside, let's take a look at micro data, which seems to be worse than macro.
According to the data collected by the Bank of International Settlements (BIS), at the beginning of 1999 debt servicing ratio (DSR) in private non-financial sector was 16 percent. As duration increased and yields decreased dramatically since then, one would expect that DSR also decreased substantially...
Wrong. At the end of last June, DSR in private non-financial sector stood at 14.8. Meaning that despite cost of debt decreasing by four times on average, costs of debt servicing did not change.
That is frightening. Because this data shows that corporations did not adjust their financing activities as the duration increased - they simply kept on piling the debts. Thus an increase in interest rates may have a severe negative effect on their balance sheets, as corporations will have to either first of all decrease duration and then deleverage, or further increase DSRs.
Technically, if every company would have cash to refinance all of their debt, increasing yields would be good. Value of debt goes down, so one can repurchase at a discount. However, according to the research conducted by S&P Global, that might not be possible for most of the companies:
- Cash and investments held by S&P Global Ratings' universe of rated U.S. nonfinancial corporate issuers rose by 10% to $1.9 trillion in 2016 as the rich get richer: The top 1% control more than half of this cash pile.
- But rising debt, now at a collective $5.1 trillion for the 99%, is a concern: Adjusted leverage for both investment-grade and speculative-grade issuers is near decade highs and, conversely, the cash-to-debt ratio near decade lows.
- At the same time, tax reform that facilitates the repatriation of roughly $1.1 trillion in cash held offshore would likely spur a wave of share repurchases, leading to lower cash balances and potentially weaker credit metrics.
Thus one may expect that most of the companies will have to refinance. As yields climb, they will be faced with two options: either to go for shorter duration, or pay higher interest on their debts.
First option is viable only in the short run and will lead to higher credit risk, which by definition means further increase in cost of financing. This is only a short-term solution because some time in the future, when the FED follows through with its plans and the situation normalizes in general, shortening duration will not be an option anymore. At some point duration will become too short for the size of the debt.
Thus deleveraging will happen. When it starts, it will affect companies' current and future free cash flows (FCF) and bottom lines, as part of the revenue will be used for deleveraging. The severity of that effect will depend on how fast some corporations will need to deleverage.
Second option will lead to higher DSRs. Thus once again putting a strain on free cash flows and net profits. Not to mention earnings before interest, tax, depreciation, amortization (EBITDA) which will be hit by both increasing base rates and yields on debt.
In addition to that, according to the data used by BIS for their research on this topic, looking at US non-financial corporations overall, the debt servicing ratio currently stands at 41.1 percent (not only private ones, under column "United States - Non-financial corporations"). Meaning that almost half of the income earned by US non-financial corporations is being used for interest payments and amortization when interest rates are at record lows. So the expectations going into monetary policy normalization should not be positive at all.
The valuations are also extremely high. Over the last years inflows to investment grade government bonds have been ever increasing. With sovereign bonds generating negative returns, investment grade corporate bonds became the new safe haven:
These inflows had a dramatic effect on corporate bond yields. For example, if one takes triple A corporate bonds with maturities 20 years and above, current yields are unseen since the 1950s (yeah, 60 years ago):
Source: St. Louis FED
Thus valuations in US corporate bond market are the highest in more than 60 years. Taking into account all of the other before-mentioned factors, this should make one think about selling at least some risk.
Sell the risk
Due to zero and negative yields, most advisers and mutual fund managers increased duration of their portfolios dramatically over the last 5 years. In addition, as described before, investment grade corporate bonds are now used instead of sovereigns. Thus most of the passive investors, who buy either mutual funds or rely on their financial advisers when forming portfolios, are at risk.
Traders and investors should decrease their risk by decreasing positions in long-term corporate bonds. That means looking into one's portfolio and selling long exposure.
The key problem is that even small fluctuations in interest rates might lead to large losses if one holds ETFs with long exposure (e.g. VCLT):
Thus, in order to avoid unexpected large fluctuations and losses, check whether ETFs and mutual funds in your portfolio have long (10 years up) exposure and sell at least some part of those.
Of course, this will decrease the hypothetical returns, nevertheless those returns will be earned only if the position is held in the portfolio for the full duration. So if you are not ready to hold that ETF for the next 20 years, switch to shorter duration.
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.