The corporate debt bubble
Corporate America living on borrowed time and money
The perverse incentives created by the monetary experiment of the past decade might be unsurprising to many responsible investors, who recognized its inherent dangers early on. However, the catastrophic consequences of artificially low interest rates and ultra-loose money policies are likely to be of a far greater scale than previously anticipated.
Rewarding reckless borrowing
In their totality, the monetary policies that were put in place to support the economy and prevent its collapse in the aftermath of the 2008 crisis have created twisted incentives. The ultra-low interest rate environment that was created and maintained by the Fed and other central banks over the last 10 years has made it historically inexpensive for companies to borrow money, encouraging the accumulation of debt, while at the same time penalizing sound financial management and responsible spending. Quite predictably, companies saw this as an opportunity to go on spending sprees and acquisition binges, using cheap credit to finance moves they wouldn’t have otherwise undertaken.
«Cognizance of the relation between a cause and its effect is the first step toward man’s orientation in the world and is the intellectual condition of any successful activity.»
Ludwig von Mises
As a result, the global non-financial corporate debt hit a record high of $75 trillion in the second quarter of this year, with US and Chinese companies being the largest borrowers. The total corporate debt in the US has exploded to $9.1 trillion, a dramatic surge of 86% from 2007, according to the Securities Industry and Financial Markets Association. Bonds rated BBB, at the riskier end of the investment-grade spectrum, have been responsible for much of this increase. Bonds in this rating class have almost tripled since 2008, now amounting to nearly $2.5 trillion.
Cash-strapped and heavily indebted
Spending sprees with borrowed money were Corporate America’s favorite pastime over the last decade and, to the short-sighted observer, it might have seemed like a harmless one. Supported by the extremely accommodative policies of the Fed, the consequences of the severe debt load that was accumulated were postponed for a future date. However, that date is now on the horizon, as interest rates rise and are set to continue to do so in the next year as well. That alone will make it hard enough for companies to service their debt, but when we also add a slowing economy, lower corporate earnings and a reversal of the bull market to the mix, it quickly becomes apparent that the risk of defaults in the not-so-distant future is considerable.
One of the key fears surrounding the future of corporate debt is the lack of cash that companies have at hand to cover their obligations. The cash-to-debt ratio of high-yield borrowers fell to 12% in 2017, its lowest point ever. By comparison, it was still around 14% in 2008. What this means in practical terms, is that for every dollar these companies have in cash, they have $8 of debt, raising a serious red flag when it comes to their ability to repay their debt.
A wave of “fallen angels”?
Another worrying trend is the downgrade potential of many companies that currently teeter on the edge of the investment-grade category. If these BBB-rated companies slide into “junk” territory, defaults are likely to multiply, while the buyer pool will shrink, tanking demand. General Electric is prime example of such a scenario. Once the most valuable company in the US, boasting a triple-A rating until 2009, GE has since taken on a massive debt load, amassing over $115 billion of outstanding debt, $20 billion of which comes due within a year. After a mass selloff following rating downgrades, the company has been struggling to retain its position within the investment-grade spectrum.
Far from a single, isolated case, the struggles of GE are bringing to the surface a much more widespread concern. An increasing number of analysts and economists predict a storm of “fallen angels”, i.e. bonds that used to be within the investment-grade range, but were downgraded to high-yield, or “junk” territory. Currently, BBB-rated bonds (that are just one to three notches above “junk”) make up almost half of all investment-grade corporate debt. Typically, downgrades are met with massive and rapid selling by the market. Also, should this “on the edge” debt be downgraded, many institutional and conservative investors, like pension funds, would be forced to unload these bonds. A wave of “fallen angels” could trigger a fierce selloff and likely pose a much wider, systemic threat. Should panic take hold, scaring off buyers and drying up liquidity, a domino of defaults would be among the most prevalent scenarios and no amount of regulation and intervention could hope to halt this descent, at least not before massive damage is done to the markets and to the economy at large.
As we stand at the end of the current credit cycle, the systematic corruption and manipulation of the economy by central bank policies that we’ve witnessed over the last decade are now catching up and it is becoming increasingly clear that there will be “nowhere left to hide” in the next recession. The sole exception is found in physical precious metals, that have remained untouched and safe from all the experimental interventions. Physical gold and silver offer a time-tested and reliable haven to the sound investor who aims at wealth preservation rather than speculation and is firmly focused on the long-term, bigger picture.
“We can ignore reality, but we cannot ignore the consequences of ignoring reality.” Ayn Rand
Claudio Grass, Hünenberg See, Switzerland
This article has been published in the Newsroom of pro aurum, the leading precious metals company in Europe with an independent subsidiary in Switzerland. All rights remain with the author and pro aurum.
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