Every Fed tightening cycle eventually exposes and leads to the collapse of the bubbles de jure. One such bubble may well be in a seemingly unlikely place. With corporate taxes being cut to 21% from 35%, corporate profit margins before the tax relief already near record highs, and the window open to tax-efficiently repatriate foreign earnings, one would logically conclude that corporations should be in robust financial health.
The chart below tells a different story, however. There is an unmistakable symmetry today with the three prior credit cycle peaks. Not only is the aggregate corporate debt to GDP ratio at record highs, but the details are devilish in their composition.
From a low of 32% in 2009, today nearly 50% of outstanding investment-grade debt is rated BBB—one rating step above non-investment-grade/speculative.
It gets worse if you slide down the quality slope as more and more investors have been willing to do as the Fed has starved them of safer alternatives. Below-investment-grade, or junk-bonds (euphemistically called high-yield), have been a hot topic of conversation since the Fed began tightening its balance sheet. Just as interest rates are on the rise, the next three years will see $430 billion in junk bonds maturing, in addition to the $1.5 trillion in investment-grade credit coming due.[1] Significant portions of those issuances were used to finance share buybacks and dividends. The heretofore unthinkable outcome: Share repurchase programs were executed at prices well above intrinsic value and refinanced with debt that becomes costlier with time, and, in extreme cases, cripples the company.
That may not even be the bottom of the credit scale, though. Leveraged loans are bank loans extended to already highly leveraged firms. They typically have floating interest rates tied to LIBOR and are senior to high-yield bonds.[2] They usually contain covenants that restrict financial operations at the company so as to not endanger its creditworthiness. Investor starved for yield seem to have become fairly undiscriminating regarding such covenants. Covenant-lite loans dispense with the usual protections. It is a borrower’s market of late. The percentage of loans issued with stripped down covenants has soared since 2012, totaling 75% in 2017.[3]
Their popularity outstrips that of high-yield bonds two-to-one. Issuance in 2017 totaled $500 billion, double that of high-yields. For comparison’s sake, new investment-grade corporate totaled $850 billion for the year.[4] High-yield bonds have seen outflows just as leveraged loans have seen inflows. Since the loans should be senior to bonds, these flows could be an attempt by investors to minimize risk. As covenants have weakened, however, loans have been allotted a greater share of the capital structure. Despite the supposed benefits to investors, if they are the lion’s share of the leverage in an over-leveraged company, seniority matters little, especially if the preference for them as a borrowing tool amplifies the susceptibility of the company to interest rate risk.[5] Worse, J. Crew has attempted to skirt its blotted loan obligations by transferring any collateral of value in the company to another entity entirely, leaving lenders little recourse.[6] If they succeed, similar moves could be attempted in the future. That is perhaps why Moody’s expects recoveries on covenant-lite loans of only 60%.[7]
Compounding the particulars of the product itself are the dynamics of the market for collateralized loan obligations (CLOs). There is strong demand for CLOs from various institutional investors. Their popularity compels banks to enter new leveraged loan agreements for the sake of fulfilling the tranches of the packaged product. The diversification of holding multiple loans is an attempt to minimize the risk of an inherently risky product. That logic seems nearly as weak as the covenants of the loans themselves!
Ultimately, the confluence of higher rates and a deluge of refinancings can easily create complications for all these products. Credit spreads should widen. The sequential tightening of financial conditions will, in due course, act as an economic brake. As the salutary effect of this year’s fiscal stimulus begins to fade, a stagnant or contractionary economy should not be ruled out.
Household Credit: In a Pinch
It is not just corporations that are under financial stress. Total consumer credit outstanding approached $4 trillion as of January 2018.[8] By year-end 2017, problematic student loans outstanding continued their ascent to $1.5 trillion, up from $1 trillion in 2012. Outstanding auto loan balances reached a record $1.1 trillion in 2017. Consumer credit card debt is $775 billion. They all follow the pattern outlined below.
To be sure, household debt service payments as a percentage of disposable income have fallen from 13.2% in Q4 of 2007, on the eve of the Great Recession, to 10.3% currently. But the picture is not so rosy if you factor in the decline in interest rates over the same period. As a benchmark against which to estimate the cost of consumer credit, the yield on the 5-year Treasury note reached 5% just before the Great Recession. By September 2017, it sank to 1.65%. The rat of higher interest rates, though, is working its way through the snake. The five-year is now trading at a yield of 2.7%. At some point, consumers facing rollovers or floating-rate debt obligations will begin to choke. That’s not good news for GDP in and of itself, but it could encourage conservatism by households as they increase their household savings, a rate currently near record lows. Unfortunately, as for the current fragile economic expansion, that’s further bad news.
In the auto loan market, higher delinquency rates have led to higher lending standards, effectively curtailing access to credit for sub-prime borrowers at the margin. Similarly, since 2016 the net charge-off rate for credit cards has been creeping up but then so has the average interest rate, from 11.8% in mid-2014 to 13.1% currently. Based on historical data, there is some price elasticity of demand for credit card debt. Whether it’s higher lending standards in auto finance or rising interest costs for credit card borrowers, an increasing segment of the borrowing public is being squeezed out. As noted regarding corporate credit above, that’s the mechanism by which expansions eventually become contractions.
Some insights are timeless. Back in 2014, Hyun Song Shin, research chief at the Bank for International Settlements, warned in a speech against the tendency to “focus on known past weaknesses rather than asking where the new dangers are.” Banks may be stronger than a decade ago, but the unregulated financial intermediation system, which has grown at the expense of the commercial banks, has taken on more and more risk, moving further and further away from its repressed state pre-1980. Even credit cycles mean revert, usually swinging far beyond equilibrium during both the expansion and contraction phases. When and where this one ends no one knows but, chances are, it will be a shock heard round the world.
[1] https://www.moodys.com/research/Moodys-Weak-structures-of-cov-lite-loans-now-the-majority–PR_367132
[2] No exact definition of leveraged loans exists. Some participants base the definition on the spread against LIBOR, since many of the loans are floating-rate. Others focus on the rating itself, which generally is below investment grade; e.g., Ba3, BB- or lower from the rating agencies Moody’s and S&P, respectively. Companies typically use a leveraged loan to finance mergers and acquisitions or buy back stock.
[3] Ibid, Moodys.
[4] https://www.wsj.com/articles/a-banner-year-for-corporate-debt-1514332051
[5] https://www.ft.com/content/2e1ff08a-c506-11e7-a1d2-6786f39ef675
[6] https://www.wsj.com/articles/deal-to-save-j-crew-from-bankruptcy-angers-high-yield-debt-investors-1506011065
[7] Ibid, Moodys.
[8] Excludes household mortgage debt of $10 trillion.
Thank you Frank. Very insightful comments as always.