With corporate debt hitting its highest levels since before the financial crisis, Moody's is warning that substantial trouble is ahead for junk bonds when the next downturn hits.Welcome to the zombie economy, central banks kept rates ultra-low for so long that companies went on a massive borrowing binge.
The ratings agency said low interest rates and investor appetite for yield has pushed companies into issuing mounds of debt that offer comparatively low levels of protection for investors. While the near-term outlook for credit is "benign," that won't be the case when economic conditions worsen.
The "prolonged environment of low growth and low interest rates has been a catalyst for striking changes in nonfinancial corporate credit quality," Mariarosa Verde, Moody's senior credit officer, said in a report. "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."
Though the current default rate is just 3 percent for speculative-grade credit, that has been predicated on favorable conditions that may not last.
Since 2009, the level of global nonfinancial companies rated as speculative, or junk, has surged by 58 percent, to the highest ever, with 40 percent rated B1 or lower, the point that Moody's considers "highly speculative," as opposed to "non-investment grade speculative."
In dollar terms, that translates to $3.7 trillion in total junk debt outstanding, $2 trillion of which is in the B1 or lower category.
"Strong investor demand for higher yields continues to allow all but the weakest issuers to avoid default by refinancing maturing debt," Verde wrote. "A number of very weak issuers are living on borrowed time while benign conditions last."
The level of speculative-grade issuance peaked in the U.S. in 2013, at $334.5 billion, according to the Securities Industry and Financial Markets Association. American companies have $8.8 trillion in total outstanding debt, a 49 percent increase since the Great Recession ended in 2009.
During that time, there's been a strong divergence in debt issuance, with investment-grade firms (shown below in the green line) pulling back as a share of total debt issuance, while speculative grade debt (the blue line) has increased.
Credit conditions have been conducive to lower-rated companies going to market, as global central banks have kept rates low and helped keep liquidity flowing through the system.
That's had some positive impacts, as smaller firms with greater access to capital have been able to implement game-changing technologies into multiple industries, particularly energy.
At the same time, higher-rated companies have been issuing debt and using it to reward shareholders with buybacks and dividends. As a result, their debt, while still investment grade, often has fallen a few notches, with the very top of the ladder shrinking from 21 percent pre-crisis to 14 percent currently.
Moody's warned that the trend could result in more "fallen angels," or companies that see their pristine ratings dinged as they continue to roll up debt.
Overall, median debt when compared with EBITDA has risen 30 percent for investment-grade companies and 10 percent for speculative.
"For many speculative-grade issuers, debt capacity may have reached its limit but structural protections continue to weaken," Verde said. "Many of these highly leveraged borrowers have more latitude than at any other time in the past to engage in potentially credit-eroding activities such as asset sales or debt-accretive transactions without needing to get lender consent."
Lower-rated companies have managed to keep their defaults below the historical average even though their credit metrics are "deeply stretched," Verde added.
"This extended period of benign credit conditions has helped many weak, highly leveraged companies to avoid default," she wrote. "These companies are poised to default when credit conditions eventually become more difficult."
Large companies borrowed to reward shareholders via share buybacks and increases in dividends, but they're mostly rewarding themselves as they manipulate earnings per share to artificially inflate their numbers and reap rewards through their bloated executive compensation scheme (based on EPS).
Smaller companies are borrowing because they need to in order to survive as many would be out of business if they couldn't borrow to run their operations.
Don't you just love modern day financial capitalism? If Marx were alive today, he would be fascinated (but not shocked) with the gross subsidization of the financial sector through "radical" monetary policy and of course direct government lending, like the famous TARP program which admittedly was paid back in full no thanks to record amount of financial and non-financial borrowing.
Anyway, as I keep repeating, pay attention to high-yield, aka junk bonds (HYG, JNK) because this remains the canary in the coal mine (click on images):
As shown above, both junk bond ETFs are hovering around their 50-week moving average so there is no imminent threat right now but if prices continue to decline or plunge (ie, spreads blow up), you should definitely take note because it could signal big trouble ahead.
When people ask me why I'm so bullish on US long bonds (TLT), I tell them it's not so much that I'm bullish on Treasuries because I hate stocks and other risk assets but it's because the global economy is slowing, risks are rising and you need to hedge downside risks. And I have yet to find a better hedge than Treasuries which remain the ultimate diversifier.
Don't get me wrong, I still risk my own capital and sometimes I take big risks. Today I was looking at shares of Mirati Therapeutics (MRTX) and wanted to kill myself because at one point, I owned 5000 shares at $5 and dumped them 50 cents higher right before the stock got slammed and hit a 52-week low of $2.70. The rest as they say is history (click on images):
Admittedly, this is a lottery ticket but believe it or not, trading biotechs, I've seen this movie a few times!!
Oh well, c'est la vie, just goes to show you sometimes you need to stop trading and just stay put (easier said than done when you're losing money as a position swings like a yo-yo but that's the nature of the biotech beast).
However, I've also witnessed plenty of biotech horror shows and counted my lucky stars I wasn't invested in them (click on images):
Like I said, it's the binary nature of the biotech beast, if you get caught in a big position, you can easily face the risk of ruin.
But it's not just biotech, I've seen plenty of big dips in my trading career and some really nasty ones in stocks like Macy's (M), Kroger (KR), General Electric (GE) and more recently Symantec (SYMC):
When people ask me "Why BONDS??", I tell them: "Because you never know what nasty surprises are lurking around the corner. Never."
Right now, things are perking up in Europe, emerging markets and those are risks we are aware of. By definition, you can measure risk, you can't measure uncertainty.
If you get caught in a brutal sell-off, you have two choices: 1) cut your losses and eat them or 2) add to your position to average down HOPING the shares will recover. Both options are painful, trust me.
Earlier this week, my father and I were talking about how it's been a while since we had a financial crisis. He was grumbling about how "Nortel was a scam and John Dunn was the only one who made money" and I told him "It was Frank Dunn and there was plenty of blame to go around".
[Note: I'll never forget a senior VP meeting at the Caisse when then CIO (Pierre something, I forget his name) was pounding the table to buy more shares of Nortel as they declined and most people agreed but if I remember correctly, Adel Sarwat wasn't too gung-ho about it but reluctantly said yes.]
My dad also asked me: "What ever happened to Lehman Brothers?" I replied: "Finito caputo!"
"You see, they're all crooks like that Dunn guy!", he said.
Why am I sharing all this with you? Because if you've been around long enough, you know one thing about markets, trends don't last forever and when the trend changes, it could be violent and it could take a very long time before things get back to normal.
In my opinion, the longer we go without a crisis and recession, the worse it will be when it strikes, both in terms of magnitude and duration.
So enjoy riding the wave in junk bonds, stocks and other risk assets, because when the tsunami strikes, it won't be pretty.
Below, Erik Townsend and Patrick Ceresna welcome Dr. Lacy Hunt to MacroVoices. I want you all to take the time to listen carefully to Lacy Hunt as he explains why the (Treasury) bond bull market isn't over and why we cannot get out of the current predicament through more debt and why it will take a long time to recover after the next crisis hits. You can also download the podcast transcript here.
I end by wishing my US readers a nice long Memorial Day weekend and by thanking my loyal subscribers and donators. If you haven't donated to this blog, please do so through Paypal on the right-hand side, under my picture. Thank you and enjoy your weekend!