Even though a bunch of US economic indicators are looking good and
interest rates are low, half of investment-grade corporate bonds are
just one notch above junk status.This could be because levered US
corporates have used their debt in ways that aren't productive for the
economy and don't contribute to corporate profitability.That means that
as the economy shows signs of slowing, weak hands could have a harder
time servicing their debt.This is an opinion column. The thoughts
expressed are those of the author.Visit Business Insider's homepage for
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“Our economy is the best it's ever been,” President Donald Trump
said while touting his administration's policies during his State of the
Union speech this week.He cited a rising stock market, low unemployment
numbers, and rising wages — which have yet to compare to precrisis boom
times but are still inching up — all as reasons to rejoice.And indeed,
consumer confidence, as measured by The Conference Board, increased to
131.6 in January from 126.5 in December. It was the survey's highest
reading since August.Unfortunately, this message of prosperity has
clearly not reached America's corporate-bond market.There, in the space
where companies trade their debt, it appears conditions are
deteriorating. As Scott Minerd, the global chief investment officer of
Guggenheim Investments, said at the World Economic Forum last month, 50%
of the investment-grade corporate bond market is rated BBB by
credit-rating agencies, a notch above the level where debt is considered
“junk bonds” (or as we now say politely on Wall Street, “speculative
grade”). In 2007 that number was 35%.
That so many companies are teetering on the edge worries Minerd,
to say the least.“We expect 15% to 20% of BBBs to get downgraded to high
yield in the next downgrade wave: This would equate to $500 [billion]
to $660 billion and be the largest fallen angel volume on record — and
would also swamp the high-yield market,” he said. “Ultimately, we will
reach a tipping point when investors will awaken to the rising tide of
defaults and downgrades. The timing is hard to predict, but this reminds
me a lot of the lead-up to the 2001 and 2002 recession.”But why worry,
Minerd？ Yes, corporate debt is high — nearing $10 trillion and pushing
the US to a record 47% debt-GDP ratio — but interest rates are low and
don't appear to be going up anytime soon. Plus, corporations have cash.
Under these economic conditions, you could argue that corporations in
need could just refinance their debt and be fine. It's why some say that
bond bears are overstating the risk here.It's what you do with itBut
there are two problems with this way of thinking. One is, of course,
that rosy financial conditions will not continue forever. The other is
that, as the folks over at the International Monetary Fund wrote in
their “Global Financial Stability Report” last fall, corporate debt “has
risen and is increasingly used for financial risk-taking — to fund
corporate payouts to investors, as well as mergers and acquisitions
(M&A), especially in the United States.”
Put another way, it isn't just that this debt exists; it's that
it's being used in ways that aren't particularly productive for the
overall economy. Balance sheets are getting loaded up, but companies
don't have much to show for it aside from soaring stock prices.Despite
the magnanimity of Trump's corporate tax cut, starting last year
business investment has been in its longest slump since 2009. Instead of
using cash to invest in things that would make the economy and their
companies more productive — like new equipment, better-trained or paid
workers, or research and development — corporate America just paid out
its shareholders and itself.In 2018, “the S&P 500 Index did a
combined $806 billion in buybacks, about $200 billion more than the
previous record set in 2007,” according to the Harvard Business Review.
Goldman Sachs called corporate buybacks “the most dominant source” of
demand for stocks last year, while warning that purchases were beginning
to wane.Say what you want about buybacks, but they don't make the
economy or a company more productive. They don't pave the way to higher
corporate profits. Neither do dividends to shareholders. And it seems
this lack of investment is starting to show in our economy. In the third
quarter of last year, productivity fell for the first time since 2015.
It is a trend that some economists, such as Ian Sheperdson, the chief
economist at Pantheon Macroeconomics, say is likely to stay with us for a
bit.“The year-over-year rate of growth of real business capex has
slowed from a recent peak of 6.9%, in Q2 2018, to just 0.3% in the
fourth quarter of last year,” he wrote in a recent note to clients.
“A dip below zero, for the first time in five years, looks almost
inevitable in the first quarter, thanks to the combination of adverse
base effects and a near-flat trend in the quarterly run rate. Against
that backdrop, we are confident that productivity growth will slow this
year, to about 1%. The fourth quarter increase was probably about 1.6%
annualized, but that's just not sustainable as businesses pull back
their spending.”A dangerous cocktailNow, combine high debt levels with a
misallocation of capital and the fact that corporate profits have been
falling for the last two quarters. Sure stocks are ripping, but
according to FactSet companies in the S&P 500 are projected to
report a 2% decline in fourth quarter earnings from the same time in
2018. That is why Goldman Sachs said stock buybacks are about to ebb
too.
For companies on the brink of junk (I'm sorry, “speculative grade”)
status high debt, low productivity and lower profits are a dangerous
cocktail. Taken all together it could make debt servicing more
challenging for companies in rough shape.For investors it's a cocktail
made all the more dangerous by the fact that corporate credit spreads
have been so tight, lulling them into a false sense of security as they
chase higher yields.
“Ultimately, this leads to what he called a Ponzi Market where the
only reason investors keep adding to risk is the fear that prices will
be higher tomorrow (or in the case of bonds, yields will be lower
tomorrow),” Minerd said in Davos.So why are so many companies teetering
on the edge of junk status in a relatively healthy economy？ Consider
this: The word credit comes from the Latin word for trust, and what the
corporate bond market may be telling us is that it can no longer trust
in corporate America's ability to invest productively, hurting profit
generation. It may be telling us that even in a world of extra low
interest rates eventually debt — and what you do with it — matters.
The Wall