Rationalizing Peak-Cycle Numbers: Investors "Unconcerned" About Record Corporate Debt

Authored by John Rubino via DollarCollapse.com,

A branch of journalism that might be called, “don’t worry, be happy, because this time is different” tends to pop up at the peak of cycles when imbalances that caused past crashes start to reemerge. Eager to keep the gravy train going, business publications send reporters out to interview industry experts (who are making fortunes from the ongoing expansion) on why this batch of imbalances is actually no problem at all. And sure enough they find all kinds of plausible-sounding rationalizations.

In the 1990s dot-com bubble, for instance, stratospheric P/E ratios didn’t matter because for New Age tech companies earnings were “optional.” In the 2000s housing bubble record mortgage debt didn’t matter because home prices would always rise faster than the associated borrowing, keeping homeowners above water and banks ever-solvent. Subsequent events proved this to be nothing more than insiders trying to keep the deals flowing.

Now, with pretty much every major indicator signaling a peak for the latest cycle, “don’t worry, be happy” is once again a popular journalistic beat. Here’s an excerpt from yesterday’s Wall Street Journal on why investors fine with record corporate debt:

U.S. corporate debt has climbed to levels that have coincided with recent recessions. Many analysts and investors are unconcerned.

Even before this week’s blockbuster $40 billion bond sale by CVS Health, corporate debt stood at 45% of GDP, a level it last reached in 2008 as the economy was entering a recession, according to Moody’s Investors Service.

Some companies with weaker credit quality are finding it easier to access the bond market, and others are skimping on covenants protecting investors. Yet analysts say the differences between the current period and 2008 and 2001—when corporate debt rose to similar levels as the U.S. tipped toward contraction—are more important than any similarities.

Today, signs of economic growth persist, supported by corporate tax cuts and a simulative budget deal, as well as borrowing costs that remain relatively low by historical standards. That means companies can continue to borrow without creating significant economic risks, according to analysts.

Moody’s predicts the economy will grow 2.7% this year and expects the default rate on corporate bonds to drop to 2.2% by year-end from 3.2% in January.

Today’s credit conditions are also stronger than in the past because of larger capital buffers held by U.S. banks as part of more stringent regulatory standards, Moody’s analysts said.

Banks’ bondholdings have shrunk drastically since the financial crisis, in part because of Dodd-Frank banking reforms but also because investors are more willing to buy the securities they underwrite. This signals an improved capacity within the economy to handle the present level of corporate borrowing.

Banks formerly held significant amounts of bonds either as unsold inventory from or with their proprietary trading units. In January 2008, the bond dealers in the Federal Reserve’s network of primary dealers who underwrite the U.S. Treasury debt held as much as $279 billion of corporate debt on their balance sheets compared with $24 billion as of last month.

Corporations are in a better position to function with higher debt burdens than in the past, some analysts said.

“The difference this time is really in the debt affordability,” said Anne van Praagh, head of credit strategy & research at Moody’s Investors Service.

The yield on the 10-year Treasury note, which serves as a benchmark lending rate for companies, has climbed this year, recently hitting a multiyear high of 2.943%, compared with an average rate of 4.63% in 2007. And with credit spreads—the difference in yield between corporate bonds and Treasury debt—hovering near multiyear lows, investor demand continues to hold down borrowing costs for most companies.

One of the fun ways to read this kind of journalism is to count the sentences likely to come back to haunt the reporter and/or his source a few years hence. The above article has a ton of them, but here are three that stand out:

“Banks’ bondholdings have shrunk drastically since the financial crisis, in part because of Dodd-Frank banking reforms but also because investors are more willing to buy the securities they underwrite. This signals an improved capacity within the economy to handle the present level of corporate borrowing.”

If there are record amounts of corporate bonds in circulation and banks don’t own them, who does? Bond ETFs and pension funds, neither of which will react well to the next downturn. ETFs will see outflows which require them to sell existing positions, thus pushing prices down even further. Pension funds will fall into a black hole of underfunding if their current investments lose value when they’re supposed to rise by a steady 7% per year. Both ETFs and pension funds are every bit as fragile and systemically dangerous as big banks were prior to the Great Recession.

“The yield on the 10-year Treasury note, which serves as a benchmark lending rate for companies, has climbed this year, recently hitting a multiyear high of 2.943%, compared with an average rate of 4.63% in 2007. And with credit spreads—the difference in yield between corporate bonds and Treasury debt—hovering near multiyear lows, investor demand continues to hold down borrowing costs for most companies.”

To note that interest rates recently hit a multi-year high but brush that off because they’re still lower than past peaks is the kind of snapshot thinking that ignores trends. And in finance it’s really all about trends. If the 10-year Treasury rate keeps rising, corporate borrowing costs will have to follow – and will eventually spike when higher interest rates destabilize the economy. Put another way, it’s not the nominal interest rate that matters, it’s the resulting interest cost. And with the world approximately twice as indebted as it was a decade ago, a lower interest rate can still generate a debilitating level of interest expense.

“Today, signs of economic growth persist, supported by corporate tax cuts and a simulative budget deal, as well as borrowing costs that remain relatively low by historical standards. That means companies can continue to borrow without creating significant economic risks, according to analysts. Moody’s predicts the economy will grow 2.7% this year and expects the default rate on corporate bonds to drop to 2.2% by year-end from 3.2% in January.”

Growth is always robust and prospects bright – according to forecasters who get paid by companies and/or governments that benefit from positive perceptions – just before something blows up and stops the expansion. In 2006, everyone from Ben Bernanke to Goldman Sachs thought 2008 was going to be a great year.

So insouciant bondholders are just following the standard late-cycle script.

Comments

Batman11 Tue, 03/13/2018 - 14:19 Permalink

We were ruled by the laws of economics and everything went to hell in a hand cart.

The economics was the problem, neoclassical economics.

A couple of fundamentals are missing that have very big implications.

1) It doesn’t understand how banks work or the monetary system

Monetary theory has been regressing since 1856, when someone worked out how the system really worked.

Credit creation theory -> fractional reserve theory -> financial intermediation theory

“A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner

http://www.sciencedirect.com/science/article/pii/S1057521915001477

2) It doesn’t consider debt

3) The early neoclassical economists hid the problems of rentier activity in the economy by removing the difference between “earned” and “unearned” income and they conflated “land” with “capital”.

Batman11 Batman11 Tue, 03/13/2018 - 14:22 Permalink

Everything goes to hell in a hand cart when you use neoclassical economics.

The 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression. No one realised the problems that were building up in the economy as they used an economics that doesn’t look at private debt, neoclassical economics.

Bring this economics back, remove 1930s regulations and repeat 1929 ......

https://cdn.opendemocracy.net/neweconomics/wp-content/uploads/sites/5/2017/04/Screen-Shot-2017-04-21-at-13.52.41.png

In reply to by Batman11

Batman11 Batman11 Tue, 03/13/2018 - 14:27 Permalink

What was the purpose of Glass-Steagall?

Glass-Steagall separated the money creation side of banking from the investment side of banking. It also stopped the money creation side of banking from trading in securities.

When the money creation side of banking can only trade in real assets there are limits on its money creation.

When the money creation side of banking can trade in securities produced by the investment side, the sky’s the limit and only dependent on the ingenuity of investment bankers in coming up with new securities. They got to work producing CDO squareds, synthetic CDOs, etc .... knowing there was a ready market that can create money out of nothing.

When the banks buy securities off each other with money they create out of nothing, you have a ponzi scheme.

https://cdn.opendemocracy.net/neweconomics/wp-content/uploads/sites/5/2017/04/Screen-Shot-2017-04-21-at-13.52.41.png

The data shows the 1920s investment bankers were more ingenious and creative leading up to 1929.

In reply to by Batman11

GUS100CORRINA Batman11 Tue, 03/13/2018 - 14:43 Permalink

Rationalizing Peak-Cycle Numbers: Investors "Unconcerned" About Record Corporate Debt

My response: One phrase: GREED realized with DEBT-LEVERAGED STOCK BUYBACKS using OTHER PEOPLE'S money.

This will NOT END WELL in the long term. GE is a POSTER CHILD for this type of CRAP where they DIVERTED their PENSION FUND contributions to buyback GE Stock so executives could enrich themselves at the expense of company financial health and long term obligations.

GE got really burned when President TRUMP won because now they look like the MARXIST PROGRESSIVE LIBERAL idiots we see everyday. Weren't they backing the CLINTON campaign with hopes of hiding their sins?

JEFF IMMELT was at the helm while all of this was going on.

In reply to by Batman11

Snaffew Tue, 03/13/2018 - 14:38 Permalink

cue the dollar's big move up tomorrow and another monkey hammer on the pm's...gotta keep the illusion going.  The pm's are respectively far too weak today---they will take them down again tomorrow.  Eventually the real market will speak, but that is likely 6 months away.

taketheredpill Tue, 03/13/2018 - 14:41 Permalink

"In January 2008, the bond dealers...held as much as $279 billion of corporate debt on their balance sheets compared with $24 billion as of last month."

So Bank inventory capacity is less than 10% of what it was in 2008?

So if/when High Yield breaks down (ala 2008) just imagine the stinkyness of the bids people will get from the banks...

Good Luck Bid-Hunters!!!

 

Iconoclast421 Tue, 03/13/2018 - 14:43 Permalink

Obviously everyone asssumes the pension funds will be bailed out, either directly through legislation, or indirectly by more Fed printing. And you'd be a fool to assume that isnt going to happen....

taketheredpill Tue, 03/13/2018 - 14:46 Permalink

"Corporations are in a better position to function with higher debt burdens than in the past, some analysts said.

“The difference this time is really in the debt affordability,” said Anne van Praagh, head of credit strategy & research at Moody’s Investors Service."

 

In a classic Credit Meltdown, Treasury yields will fall but Corporate Yields will rise (a lot) as yield spreads blow out.  So Interest Payments will suddenly go up (a lot) and I guarantee nobody will be talking about "debt affordability".  

 

ichan Tue, 03/13/2018 - 15:01 Permalink

They can do whatever they want. Just make sure the participants all hang when the bottom falls out. NO MORE FUCKIN' BAILOUTS.

Davidduke2000 Tue, 03/13/2018 - 16:49 Permalink

investors are riding a wave of fraud that will end really bad, but they believe they can exit fast not knowing the bottom would drop before they blink their eyes.

Bemused Observer Tue, 03/13/2018 - 16:49 Permalink

The investors are in the process of disemboweling the goose. They're still coming across eggs as they dig through the blood and guts, but it is safe to say that goose will NOT be laying any more eggs. What they see is what they get, then that's it, there is no more.

They are gutting and bleeding business after business...not creating jobs, but destroying them. They don't care about debt because the survival of the company is not their goal. Their goal is to strip the 'value' out of the company before the inevitable bankruptcy, and if debt is needed to keep it on life support while that happens, that's just fine.