This morning's media blitz by Carl iCahn - demanding that AAPL's Tim Cook, borrow money cheap, lever-up, and gift it all back to shareholders through buybacks - reminded us of our previous post on the record high levels of leverage in US corporations. To a point, firms can add debt as earnings and equity value increase - leaving leverage and credit risk somewhat constant. However, the last few years, in spite of Maria Bartiromo's constant drivel of cash on the balance sheets, companies have increased debt faster than EBITDA, leverage is at record levels, and credit markets appear to have peaked (as they did in 2007).
U.S. equities have made new highs in the past 10 months while IG corporate credit has not rallied past 130bp (despite all the liquidity provision)...
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The inverse relationship between equity prices and credit spreads has broken down - as additional debt has risen faster than EBITDA
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Leading to pre-crisis levels of leverage (and implicitly credit risk) - which should mean wider spreads but thanks to the liquidity (for now) is being held at merely record low "stable" levels...
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But we have seen this "credit cycle end, equities ramp" before - in 2007 - where leverage (both firm-wise (debt/EBITDA) and instrument-wise (CDOs)) provided the extra oomph to send stocks higher on the back of credit fueled extrapolation of earnings trends.
(charts: Barclays)
In the end we know this is unsustainable - the question is when (in 2007 it last 10 months or so...).
We already see 30Y Apple bonds trading at 5% yields - admittedly low still but notably higher than when they issued previously. The Verizon deal recently now trades at around 5.7% yield and is considerably worse financially pro forma. Of course, just as in 2007, things change very quickly once collateral chains start to shrink.
Perhaps this is why Carl iCahn said the Apple CFO/CEO shunned him - iCahn's worst nightmare is simply the inability to proxy-LBO each and every firm...
Given these charts - which market do you think is in a bubble - equity or credit? Bear in mind that the Fed's Jeremy Stein has already made his case that the latter is a bubble for sure... and the fragility that reaching for yield creates...
Full Stein paper here:
Stein 20130926 A [12]
Of course, we discussed this previously and as a bonus here are a few extra charts as a bonus...
...pretty much every other credit metric is deteriorating...
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and the credit cycle is getting long in the tooth...
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We suspect we are in Stage 13 of the 14-Stage credit cycle [16] from credit expansion to speculative bust...
2. Overextended Credit Expansion and Over Capacity
3. Financialization and Collateral
4. Era of Financialization
5. Growing Malinvestment
6. Phantom Collateral from Asset Bubbles
7. Bubble Implosions
8. Impaired Debt and Policy Decisions
9. Stalled Consumption
10. Cheap Money Offered
11. Shrinking Loans and Bank Speculation
12. Search for Yield from Shrinking Pool of Productive Assets
13. Increasingly Speculative Investments with high Risk <---- YOU ARE HERE
14. Stagnation: Over-indebted, overcapacity with limited growth
The key dynamics here are debt saturation and diminishing returns...
It seems to us that the corporate bond market (now absent the underpinning of a dominating retail technical flow) has reverted back to the macro background reality.... the question is - what happens when the equity market 'admits' that perhaps things are not so rosy...
Remember corporate credit risk reflects just as much on the underlying business volatility and cashflow outlook as the equity part of the capital structure. There are periods in the credit cycle when credit will underperform as management relevers (i.e. buybacks/dividends) but that always only lasts a brief time as credit begins to penalize those actions, making the re-levering non-economic, and an over-expectant equity market reverts back to a less-levered reality.