With the recent 10th anniversary of the bankruptcy of Lehman Brothers (largest bankruptcy in US corporate history), many investors are once more worried that another financial crisis is coming soon. The media is full of stories warning about the next potential catalyst for a capital market/economic/market meltdown.
In fact, since the Great Recession ended there has been a steady stream of doomsday prophets warning that the economy and stock market (SPY) (DIA) (QQQ) was about to collapse. Probably the most hyperbolic and sensational was economist and author Robert Wiedemer's 2011 prediction that inflation was set to soar to 100%, the stock market would crash 90%, and unemployment would hit 50% by 2013.
Last week in part one of this five part series I explored why another financial crisis is indeed inevitable, though unlike the cataclysm of 2008-2009, probably won't be caused by record high consumer debt. More importantly, I explained that while financial crises (anything that significantly increases financial stress) are more frequent than people realize, they don't typically tend to cause recessions or bear markets.
In part two of this series, we'll explore a larger risk to the global financial system, which is record high US corporate debt. Specifically, we'll examine the five most important things investors need to know about this important topic. That includes: just how big of a problem this is, what kind of damage it could do, but most importantly, why it's not a good reason for investors to change their long-term asset allocation plans.
1. Corporate Debt Hits Record Highs
There is no denying that US corporate debt levels have been steadily rising for decades, and are at record highs. In fact, since 2008's previous peak, companies have added over $2.5 trillion to their balance sheets, which now hold over $9 trillion in debt.
Financial bears and doomsayers correctly point out that this corporate debt binge has largely been made possible by major central bank money printing. Between 2007 and 2018, global central bank quantitative easing or QE (money printing to buy bonds) increased global liquidity by a staggering $11 trillion.
That, in turn, resulted in borrowing costs continuing their decades-long trend of declining to the lowest levels in history.
But the biggest risk that many correctly point out is that it's not just large and well capitalized blue chips that are borrowing vast amounts. It's also shaky companies with poor balance sheets, and track records of bad capital allocation. These companies have sub investment grade (beneath BBB-) credit ratings and thus must borrow in the high-yield or junk bond market. In recent years junk bonds have grown to make up about 60% of the total US corporate debt market.
The trouble is that junk bond yields can soar during times of economic or industry distress. During the worst oil crash in over 50 years (when crude fell 76% peak to trough), junk bond yields nearly doubled to just over 10%. That was because the credit market worried about deeply indebted oil companies going bankrupt (over 330 did).
So let's take a closer look at the junk bond market, to see how worried investors should be about this form of corporate debt triggering another financial meltdown.
2. Junk Bonds Are The Biggest Risk
According to UBS US companies now have $4.3 trillion in low-quality junk bonds, which is up from $2.4 trillion in 2010. That certainly does increase the risks of rising defaults in another economic downturn which is why Mark Zandi, chief economist for Moody's, says “I view this as the most severe threat to the economy and financial system.” Thus financial crisis bears certainly have some solid reasoning to justify their fears that another meltdown is coming soon.
According to Mariarosa Verde, Moody's senior credit officer:
"the prolonged environment of low growth and low interest rates has been a catalyst for striking changes in nonfinancial corporate credit quality...The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives." - Mariarosa Verde
In May of 2018, Moody's estimated that corporate bonds rated B1 or lower (highly speculative), totalled about $2 trillion. For context, that's roughly equal to US credit card and auto loan debt combined.
(Source: Motley Fool)
As Moody's warns, many of these junk bond issuing companies are living on borrowed time and will see increasing financial distress as interest rates rise.
"Strong investor demand for higher yields continues to allow all but the weakest issuers to avoid default by refinancing maturing debt. A number of very weak issuers are living on borrowed time while benign conditions last....This extended period of benign credit conditions has helped many weak, highly leveraged companies to avoid default...These companies are poised to default when credit conditions eventually become more difficult." - Mariarosa Verde
Today financial conditions for weak companies are indeed getting more difficult. That's both in the form of rising short-term borrowing costs (Fed is planning six more rate hikes through the end of 2020), and longer-term borrowing rates. That's courtesy of the Fed's balance sheet rolloff plan, which on October 1st hit its peak of up to $30 billion in maturing 10 year US treasury bonds that it won't be rolling over into new purchases.
(Source: Yardeni Research)
By 2023 the Fed's current plan calls for its balance sheet to be back to pre-crisis levels, which will mean much higher long-term borrowing costs for sub investment grade companies. That's because junk bond yields are correlated to long-term (10 year) US treasury yields.
Another concern is that the Fed is hardly the only central bank pulling back the punch bowl of cheap credit. While the US Federal Reserve was the first to end QE, the European Central Bank or ECB, has announced it would cut its $35 billion per month bond buying program in half in September. And by the end of 2018, it plans to discontinue it entirely. While the ECB has no firm plans to roll off its balance sheet, the point is the global liquidity that has helped to support low corporate borrowing in general, and junk bond borrowing in particular is now ending and starting to reverse. That bodes poorly for many companies who have relied on high investor demand for high-yield debt, especially "covenant lite" leveraged loans.
Leveraged loans are made to companies (and individuals) who already have dangerously high amounts of debt. In the past, many of these loans had strict debt covenants, which are financial metric requirements (such as debt/EBITDA or interest coverage ratios) that companies must maintain at all times. If a borrower breaches a covenant the lender can call in the loan immediately. Thanks to high demand for junk bonds and leveraged loans, the amount of loose lending has increased significantly. During the financial crisis covenant lite loans saw loss rates of 44%. During previous recessions losses usually averaged 22%. For context, recently junk bond default rates were just 3%.
But high future loan losses on junk bonds are far from the only reason for investors to hate high corporate debt levels. Super cheap credit has also potentially created large capital misallocation, as seen by the rise of zombie corporations.
3. Super Cheap Debt Fuels The Rise Of Zombie Companies
The Bank Of International Settlements or BIS monitors the amount of Zombie companies in 14 developed economies. Zombie firms are those who are 10+ years old (mature), and whose earnings before interest and taxes (EBIT) fails to cover their debt servicing costs. These companies are essentially already in default (thus insolvent). But these walking dead firms are often kept alive by refinancing or restructuring debt to stave off liquidation. This cuts off the most important part of capitalism.
(Source: Bank of International Settlements)
That would be the "creative destruction" that occurs when poor capital allocators go bust, and healthier and better run companies buy their assets for pennies on the dollar during bankruptcy sales. Or to put another way, for capitalism to work best, and economies to grow and become more efficient (productivity growth), bad companies have to be allowed to fail. Otherwise, they continue to drag on the global economy by holding onto limited resources that could be far better used by healthier companies.
Zombie firms have increased 500% since 1985. They became far more prevalent during the 1990's. That was when Japan, suffering from two epic popped bubbles (stocks and real estate), decided to bail out its financial industry and keep many failed companies on life support. The infamous "lost decades" it's suffered ever since are often attributed to keeping mismanaged companies alive long after they should have been allowed to die. Long-term economic growth is ultimately a function of two things, labor force growth, and productivity growth. The more zombie firms exist and soak up valuable resources, the slower productivity grows, and thus overall economic expansion rates are lower.
Basically, this means the global monetary tightening we're now seeing might be a good thing because it finally "clears the brush" by killing off companies bailed out by a decade of global QE and record low interest rates. But that means that gradually rising rates should be seen as a reason for optimism, not as a potential source of economic collapse.
But what about that record high corporate debt, specifically the junk bonds? Wouldn't a mass die off of zombie companies, including numerous financial companies, mean a large financial crisis that guts the economy and sends the stock market plunging? Well actually no, for two main reasons.
4. Why Corporate Debt Is Unlikely To Trigger Another Economic Meltdown
First, let's address the issue of zombie companies finally being put in the grave. Note that most of these companies are small energy and financial firms. And those financial companies are not large systemically important banks, but rather shaky companies like subprime auto lenders and issuers of credit cards to people with poor credit. Their failure, while painful for investors and employees in such firms, isn't the stuff economic meltdowns are made of.
What about publicly traded zombie corporations? Won't those sink the stock market during the next recession? Actually, zombie firms make up just 10% of US stock market capitalization. Thus even if they were to completely die off tomorrow, it probably wouldn't even trigger a correction, much less a huge market crash. Remember that the major indexes (that dominate the increasingly popular passive index ETF and fund industry) are market cap weighted. That means they are dominated by strong giants like Apple (AAPL), Amazon (AMZN), and Microsoft (MSFT). In 2017 according to Deutsche Bank, we saw significantly increased zombie company die off due to rising rates. Did the stock market crash? No, it soared 20%, thanks to thriving blue chips rising strongly.
Ok, so maybe zombie firms, the biggest abusers of junk bonds and covenant lite leveraged loans, won't trigger a financial crisis or stock market crash. But what about that giant corporate debt held by blue chips? Won't that cause a lot of bankruptcies of large companies that could have disastrous repercussions on the economy and stock market? Actually, probably not.
According to Francesco Curto co-head of research at DWS, Deutsche Bank’s majority-owned asset management company:
“The red flags are not going up yet because to a large extent the level of interest rate is actually quite benign...So I wouldn’t say there are major concerns there — the ratings of these companies to a large extent are still positive.” - Francesco Curto
The reason Deutsche isn't worried is largely due to the record amount of corporate cash ($2.1 trillion) US companies have on their balance sheet. The cash/debt ratio for US companies fell to 12% in 2017, which is actually down from 14% in 2008. In other words, relative to the cash available to pay down debt, corporate debt levels are not actually at record levels. That's despite borrowing so heavily in recent years largely to fund a historic boom in buybacks.
Another thing to keep in mind is that while corporate debt is at all time highs, as a percentage of market cap it's actually at some of the lowest levels in recorded history. Only during the crazy tech boom, (biggest US bubble in market history) of the late 1990's was corporate debt/market cap significantly lower.
Remember that companies can tap equity markets to issue new shares to raise capital, including for paying back debt if they have to. And while true that stock prices (and thus market cap) are volatile, the point is that corporate debt levels are far from dangerous enough to justify either losing sleep or the kind of doomsday predictions that are so popular today.
Most importantly, the biggest reason that record corporate debt doesn't have me sitting in 100% cash, while awaiting an epic financial meltdown and market implosion, stems from who owns it. According to USA Today, "The shaky corporate debt is largely held by an assortment of private equity firms, hedge funds, insurance companies, mutual funds and other financial companies."
The reason 2008-2009 was so damaging is that it was the systemically important financial institutions or SIFIs (too big to fail) banks that owned most of the highly leveraged and toxic subprime mortgage based derivatives. In fact, at its 2008 peak the global derivatives market, most of it based on sub prime toxic assets, reached $668 trillion. For context, this means that dangerous derivatives were about 11 times larger than the entire global economy. Financial giants (some leveraged at 30X) like AIG (AIG) wrote $3 trillion in subprime derivatives alone (credit default swaps). All while reserving nothing to back any potential future claims (losses).
Basically, because it was the major banks and insurance companies that were crazy leveraged into these ticking time bombs, when the housing market imploded it was the largest banks and insurance companies on earth that were threatened with extinction. That's what froze credit markets solid and led to that first initial wave of QE from central bankers (largely believed to have prevented a global depression).
Today there are tons of corporate bonds out there, true. And trillions of dollars worth of horribly dangerous junk bonds, including to zombie companies that are doomed. But guess what? While rising interest rates are certain to cause numerous business failures in the coming years, that doesn't necessarily mean that corporate debt is likely to cause another financial crisis, much less an economic or market meltdown.
5. Financial Crises Are Common BUT Most Don't Cause Recessions, Much Less Market Crashes
In my last article, some commenters accused me of trying to scare people by saying that, "on average a major financial crisis has occurred every four years since 1982". So it's important to remember what a financial crisis is, and is not. It's not a repeat of 2008-2009, which was the worst capital market collapse since the Great Depression. Rather it's any domestic or global event that badly disrupts capital markets and causes significant increases in financial stress. One can argue over what should or shouldn't make the cut when defining financial crises, but most analysts agree that these are the major ones of the last few decades:
- 1982: Latin American sovereign debt crisis: resulted in IMF bailout
- 1980's US Savings and Loan crisis: resulted in over 700 S&Ls going bust
- 1989 US Junk Bond crash: resulted in bankruptcy of Drexel Burnham Lambert, the fifth largest investment bank of its day
- 1994's Tequila Crisis/Mexican Currency crash: resulted in $50 billion US government bailout/loan guarantee
- 1997-1998 Asia/Russia Currency Crisis: Resulted in $40 billion bailout by IMF and Fed orchestrated bailout of Long-Term Capital Management, a hedge fund with $126 billion in AUM at its peak
- 2000-2002 Dot Com Bubble: Nasdaq fell 80% peak to trough, many tech stocks fell more, numerous went bankrupt
- 2007-2009 Financial Crisis: subprime mortgage/toxic derivatives-based meltdown
Note that just two of these coincided with recessions and market crashes (40+% bear market). The rest merely rattled the bond markets and some triggered run of the mill stock corrections.
The St. Louis Fed's financial stress index tracks 18 financial indicators on a weekly basis. A reading of zero signifies average financial stress (since 1994). Note that in the past 24 years, we've never had a recession with the index not hitting at least one. And since 1994 four major financial crisis have struck, each of which has pushed financial stress to 1 or slightly above (my definition of "significant stress").
I also included the Great Oil Crash of 2014 to 2016 in the above chart. That's to highlight that even with over 330 energy company bankruptcies, and junk bond yields doubling (massive disruption to corporate lending), overall US financial stress didn't even hit its average level. In other words, this is strong evidence that it would take an epic meltdown in the junk bond market to put us at risk of even a mild recession. Junk bonds triggering a financial meltdown? Given that it's not SIFIs that own most of those bonds, such a thing is extremely unlikely.
Bottom Line: Record Corporate Debt Is A Risk To Be Aware Of, But Not Likely To Trigger Another Economic Or Market Meltdown
It's understandable that investors get nervous about companies borrowing trillions during a record low rate environment. And I'm certainly not a fan of companies using much of that money not to invest in high return future growth, but share buybacks or to fund unsustainable dividends.
Please don't misunderstand me, I'm NOT saying you should ignore corporate debt levels. The most important part of any income investment is the dividend profile which consists of three things: yield, dividend safety, and long-term growth potential. Dividend safety is the most crucial thing to focus on. A healthy balance sheet (modest leverage ratio by industry standards, strong interest coverage ratios, low risk of covenant breaches) is something I look for in every stock I own.
So, by all means, be aware of corporate debt, both at a company and economy wide level. But just remember that absolute debt levels are far less important than relative debt levels. As the economy and corporate earnings, cash flow, and market caps grow, corporate America's ability to safely shoulder more debt grows with it.
And as for record high junk bonds and covenant lite leveraged loans? Well remember those mostly affect companies that deserve to die anyway. In fact, the death of zombie companies is actually beneficial to the economy (and stock market) in the long-term. More importantly, zombie firms are mostly concentrated in energy and non-strategically important financial industries. They also make up just 10% of overall US stock market capitalization. So even if they were all to fail overnight, it would likely cause only a minor market drop, probably not even a correction, much less a full blown crash.
The bottom line is that while record corporate debt is troublesome (might slow rate of future investment and dividend growth), it's not an existential threat to the US or global financial system. It's certainly not a reason to change your long-term asset allocation (investing) strategy. Most importantly, it doesn't support the kind of sensationalistic claims such as made by permabear Peter Schiff that the next recession will be "worse than the Great Depression". When you see such headlines, recognize them for what they are. That would be clickbait designed to grab attention and gin up ad revenue; not provide sound long-term financial advice.
Disclosure: I am/we are long AMZN.
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.