I rarely follow former FOMC Board Members as too often their "private-sector-personas" are way tougher than their "sitting-on-the-board-guises". However, this morning's Bill Dudley's Bloomberg Opinion piece caught my attention - "Two Risks to Stability Build Amid Short-Term Calm".
Sure, his economic orthodoxy shines through with his "chronic budget deficits require large increases in the supply of Treasury debt" rhetoric. I have little interest in discussing the first risk Bill highlights in his article. Most readers know I am a huge fixed-income grizzly, not because we will have trouble selling debt, rather due to what I believe will be an increase in inflation in the coming years. However, you don't need another bearish bond diatribe from me.
But the other risk Dudley singles out is interesting. From the article:
The second long-term risk is the buildup of corporate debt — especially in the BBB rated and high-yield areas. In recent years, U.S. corporations have taken advantage of low interest rates and narrow corporate credit spreads to increase their leverage and move down the credit-quality curve. For many chief executive officers, the calculus has been simple — more leverage facilitates greater share buybacks. That shrinks the number of shares outstanding, boosting earnings per share and the company’s stock price.
This is all incredibly pleasant during a period of sustained economic expansion. But as Ed McKelvey and I wrote two decades ago, there is a dark side to the brave (i.e., longer) business cycle. When recessions become less frequent, the shock of recession becomes greater when they do ultimately occur; this leads, inevitably, to greater turmoil in financial markets. Recent recessions, such as the 2000-01 bursting of the technology stock bubble or the 2007-09 financial crisis, have a greater financial instability component compared with earlier economic downturns.
This pattern is unlikely to be broken next time. After all, the growth in corporate debt has been concentrated in the BBB rated sector.
Dudley is correct in his analysis that corporate debt growth has been concentrated in the BBB-rated sector. In fact, BBB-rated issuance has never been a higher portion of the Investment Grade (IG) universe.
BBB is the last credit rating before an issuer is kicked out of the Investment Grade bond index. Ok, so what? Well, being removed from IG and getting delegated to the High-Yield (HY) index is like getting sent down to the minors. Your debt costs rise and the available pool of buyers shrinks.
[As an aside, not being from the bond world, I was curious how this demotion to high-yield works, so I reached out to my favourite credit fund. They explained the following:
"BBB- is the lowest IG rating. A company needs 2 rating agencies to downgrade to HY (BB+ and below), once this happens, index-based investors that can’t own HY by mandate typically have to dispose of the bonds. If only 2 rating agencies rate the security and one of them downgrades to HY, then some mandates may also have to sell." ]
The preponderance of BBB issuers was first brought to my attention at a client dinner where the famous Canadian bear David Rosenberg was the guest speaker [The Triple B Problem]. At the time David argued the huge amount of BBB issuers would be more bearish for the economy and the equity market as CFOs would do everything in their power to maintain their Investment Grade status. That might mean slashing CapEx. Heck, they might even cut back on their stock buybacks. Anything (and everything) to make sure their credit rating didn't slip to high-yield.
Over the past year, triple BBB issuers have done a remarkable job of dealing with market participants' concerns. In fact, Rosie's prediction that shorting credit on this worry would not yield fruitful results was spot on.
Even though BBB is the largest part of the IG universe, year-to-date, it has outperformed higher quality paper.
Here is the return of the Bloomberg Barclays Index of A's vs BBB's:
Another way to think about this is to examine the option-adjusted-spread of the different sections of the IG universe. For example, here is the extra yield that a BBB issuer pays versus that of an AAA issuer:
Notice how for the entire 2019 this spread has been narrowing. This means that investors are demanding less extra yield to compensate for the lower credit quality of the BBB issuers.
But wait! Aren't BBB issuers becoming a larger and larger portion of the IG universe? Surely that extra supply should cause spreads to widen, not tighten.
And this is exactly what Dudley is worried about. The longer this BBB bid lingers, the bigger will be the ultimate problem. Again, from Dudley's op-ed:
When the next recession occurs, a significant portion of this debt will be downgraded to junk. Credit spreads for this debt will rise because of the deterioration in quality.
But the story isn’t likely to end there. Forced selling will generate significant congestion within the corporate debt market. After all, many investors with mandates that restrict holdings to investment-grade debt will have to unload their newly junk-rated bonds. This selling will push securities prices below their underlying value. Prices will have to become overly cheap to provoke opportunistic buying.
I used to think this worry about BBB debt was overblown. It seemed to me that too many investors were looking for a repeat of 2008 and hedging against a credit collapse.
Remember Carl Icahn's Danger Ahead? It was 15 minutes of Carl warning about the coming disaster in corporate credit.
The problem is that this was released in September... of 2015. Now, I have probably incorrectly been calling for inflation to return for at least that long, so I will retreat to my glasshouse and not throw any stones at Carl. But I want to illustrate how long many within the hedge fund community have been warning about a coming credit crisis.
For the longest time, calling for a repeat of the 2008 crash was simply "too easy". It sounded smart. In fact, you got to keep company with some shrewd (and rich) hedge fund managers. In short, it required little fighting against the crowd.
Therefore, it seemed clear to me that if it was so obvious, it was obviously wrong. Rosie's argument that companies would find a way to stickhandle through the high-yield zone at all cost resonated with me.
What's interesting now is that Dudley is making the same forecast that hedge fund managers have been arguing for the past five years.
Although I have no idea of the timing, as this cycle continues, I am getting more sympathetic to the idea credit is a time bomb waiting to happen.
And let me tell you why. The other day, I was out for drinks with a smart seasoned distressed debt investor. I was so out of my league, I felt like Samwise Gamgee at the council of Elrond. This guy just knew that much more than me. I floated the idea that BBB credit was not that scary because companies would do whatever it took to stay out of the high-yield penalty box.
Like Gandalf schooling a young foolish Hobbit, he told me,
"Yeah, that works fine when the economy is chugging along. No doubt that companies will take extraordinary measures to maintain their IG rating. However, when the next recession - actually scratch that - when the next decent economic slowdown hits, these companies will have zero ability to cut anywhere near enough CapEx to stop downgrades. They are skating that close to the edge. And the BBB guys are not the ones doing big stock buybacks, so that will not be an option to stop the slide either. These over-levered companies will have zero ability to arrest the descent to high-yield. And when it starts, it will feed on itself."
My wise elder is way too smart to predict when this will happen. Instead, he is sitting around, biding his time, waiting to buy distressed bargains from the overzealous traditional portfolio managers when the crisis hits.
However, it struck me that he was right. When the economy turns, this BBB bulge will be a problem.
And to make matters worse, Dudley brings up another fact that I was not aware of:
Moreover, some of the changes made in the 2017 Tax Cuts and Jobs Act will increase the stress on highly leveraged companies. In particular, the law eliminated companies’ ability to offset losses during an economic downturn with refunds of federal corporate income taxes paid in earlier years. Also, the law limits the deductibility of interest relative to earnings before interest, tax, depreciation and amortization. As Ebitda falls in recession, those constraints will become more binding, further restricting the cash flow of highly leveraged companies. The increase in corporate debt leverage should not make a recession significantly more likely. However, when a recession does occur, the debt burden and the tax law will make the economic downturn worse.
Now, this isn't a call to load the boat up on CDS protection like Icahn is advocating. We might still be another year or two away from the credit market rolling over. I have no clue regarding the timing.
But it is a warning that the longer we continue this game of stuffing more and more leverage into increasingly worsening credits, the bigger the ultimate correction will prove. BBB-rated companies were some of the best performing bond issuers this year. I doubt they will be next year.
Thanks for reading, Kevin Muir the MacroTourist