Ten years after the Lehman bankruptcy, the financial elite is obsessed with what will send the world spiraling into the next financial crisis. And with household debt relatively tame by historical standards (excluding student loans, which however will likely be forgiven at some point in the future), mortgage debt nowhere near the relative levels of 2007, the most likely catalyst to emerge is corporate debt. Indeed, in a NYT op-ed penned by Morgan Stanley's, Ruchir Sharma, the bank's chief global strategist made the claim that "when the American markets start feeling it, the results are likely be very different from 2008 — corporate meltdowns rather than mortgage defaults, and bond and pension funds affected before big investment banks."
But what would be the trigger for said corporate meltdown?
According to a new report from Goldman Sachs, the most likely precipitating factor would be rising interest rates which after the next major round of debt rollovers over the next several years in an environment of rising rates would push corporate cash flows low enough that debt can no longer be serviced effectively.
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While low rates in the past decade have been a boon to capital markets, pushing yield-starved investors into stocks, a dangerous side-effect of this decade of rate repression has been companies eagerly taking advantage of low rates to more than double their debt levels since 2007. And, like many homeowners, companies have also been able to take advantage of lower borrowing rates to drive their average interest costs lower each year this cycle.... until now.
According to Goldman, based on the company's forecasts, 2018 is likely to be the first year that the average interest expense is expected to tick higher, even if modestly.
There is one major consequence of this transition: interest expenses will flip from a tailwind for EPS growth to a headwind on a go-forward basis and in some cases will create a risk to guidance. As shown in the chart below, in aggregate, total interest has increased over the course of this cycle, though it has largely lagged the overall increase in debt levels.
The silver lining of the debt bubble created by central banks since the global financial crisis, is that along with refinancing at lower rates, companies have been able to generally extend maturities in recent years at attractive rates given investors search for yield as well as a gradual flattening of the yield curve.
According to Goldman's calculations, the average maturity of new issuance in recent years has averaged between 15-17 years, up from 11-13 years earlier this cycle and <10 years for most of the late 1990’s and early 2000’s.
And while this has pushed back the day when rates catch up to the overall increase in debt, as is typically the case, there is nonetheless a substantial amount of debt coming due over the next few years: according to the bank's estimates there is over $1.3 trillion of debt for our non-financials coverage maturing through 2020, roughly 20% of the total debt outstanding.
What is different now - as rates are finally rising - is that as this debt comes due, it is unlikely that companies will be able to roll to lower rates than they are currently paying. A second source of upward pressure on average interest expense is the recent surge in leverage loan issuance, i.e., those companies with floating rate debt (just 9% in aggregate for large caps, but a much larger percent for small-caps). The Fed Funds Futures curve currently implies four more rate hikes (~100 bp) through year-end 2019 (our economists are looking for 2 more than that, for a total of six through year-end 2019). While it is possible that some companies have hedges in place, there is still a substantial amount of outstanding bank loans directly tied to LIBOR which will result in a far faster "flow through" of interest expense catching up to the income statement.
While rising rates has already become a theme in several sectors such as Utilities and Real Estate, Goldman warns that this has the potential to be more widespread:
We saw evidence of this during the 2Q earnings season, where a number of companies cited higher interest expense as a headwind to reported earnings and/or guidance. Some examples:
- “... we’re anticipating an increase in interest. It’s going to be n probably up in the $3.5mm, $4mm range, depending on interest rate increases... Obviously, we are anticipating floating rate increases if you think through the rate curve, so we embed that thinking into our forecast.” - Brinker International, FY4Q2018
- “We expect net interest expense will be approximately $144 million [vs. $128 mn for the year ending February 3, 2018], reflecting an expectation for two additional rate increases as implied by the current LIBOR curve.” - Michaels Cos., 2Q2018
- “Due largely to the effects of rising interest rates on our variable rate conduit facility, vehicle interest expense increased $9 million in the quarter... We continue to expect around $20 million higher vehicle interest expense due to rising U.S. benchmark interest rates.” - Avis Budget Group, 2Q2018
What does that mean for the bigger picture?
While many cash-rich companies have a remedy to rising rates, namely paying down debt as it matures, this is unlikely to be a recourse for the majority of corporations. The good news is that today, corporate America looks extremely healthy against a solid US economic backdrop. Revenue growth is running above trend, and EPS and cash flow growth are even stronger, boosted by Tax Reform.
And while Goldman economists assign a low likelihood that this will change anytime soon, there has been a sharp pickup in the “Recession 2020” narrative as of late. Specifically, along with the growth of the fiscal deficit which will see US debt increase by over $1 trillion next year, the fact that debt growth has outpaced EBITDA growth this cycle has implications for investors if and when the cycle turns.
Which brings us round circle to the potential catalyst of the next crisis: record debt levels.
According to Goldman's calculations, Net Debt/EBITDA for its coverage universe as a whole remains near the highest levels this cycle, if not all time high. And while the bank cannot pinpoint exactly when the cycle will turn, it is easy to claim that US companies are “over-earning” relative to their cycle average today, a key points as the Fed continues "normalizing" its balance sheet. Indeed, this leverage picture looks even more stretched when viewed through a “normalized EBITDA” lens (which Goldman defines as the median LTM 2007 Q1-2018 Q2).
There are two main factors that have driven this increase: net debt has increased while cash levels have declined:
- the % of highly levered companies (i.e. >2x Net Debt/EBITDA) have nearly doubled vs. 2007 levels (even after EBITDA has improved for a large part of the Energy sector.)
- The number of companies in a net cash position has declined precipitously to just 15% today down from 25% from 2006-2014.
Meanwhile, and touching on another prominent topic in recent months in which many on Wall Street have highlighted the deterioration in the investment grade space, i.e., the universe of "near fallen angels", or companies that could be downgraded from BBB to junk, Goldman writes that credit metrics for low-grade IG and HY have been moving lower. If the cycle turns, the cost of debt could increase, with convexity suggesting that this turn could happen fast.
Picking up on several pieces we have written on the topic (most recently "Fallen Angel" Alert: Is Ford's Downgrade The "Spark" That Crashes The Bond Market"), Goldman specifically highlights the potential high yield supply risk that could unfold.
Here are the numbers: currently there are $2tn of non-financial bonds rated BBB, the lowest rating across the investment grade scale. The amount has increased to 58% of the non-financial IG market over the last several years and is currently at its highest level in the last 10 years.
And for those wondering what could prompt the junk bond market to finally break - and Ford's recently downgrade is precisely such a harbinger - Goldman's credit strategists warn that this is important "because a turn in the cycle could result in these bonds being downgraded to high yield."
From a market standpoint, too many bonds falling to the high yield market would create excess supply and potentially pressure prices. Looking back to prior cycles, approximately 5% to 15% of the BBB rated bonds were downgraded to high yield. If we assume the same percentages are applied to a theoretical down-cycle today, a staggering $100-300bn of debt could be at risk of falling to the high yield market in a cycle correction, an outcome that would choke the bond market and shock market participants. It is also the reason why Bank of America recently warned that the ECB can not afford a recession, as the resulting avalanche of "fallen angels" would crush the high yield bond market, sending shockwaves across the entire fixed income space.
And while such a reversal is not a near-term risk given solid sales/earnings growth and low recession risk, "it is potentially problematic given the current size of the high yield market is only $1.2tn."
Should the market indeed turn, prices would need to adjust - i.e. drop sharply - in order to generate the level of demand that would require a potential 25% increase in the size of the high yield market – especially at a time when risk appetite could be low.
Careful not to scare its clients too much, Goldman concedes that an imminent risk of a wave of credit rating downgrades is low, but warns that "the market could potentially be overlooking the underlying cost of capital/financial risks (high leverage, low coverage) for certain issuers based on their current access to market."
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As for the worst case scenario, it should be self-explanatory: a sharp slowdown in the economy, coupled with a major repricing of bond market risk could result in a crash in the bond market, which together with the stock market has been the biggest beneficiary of the Fed's unorthodox monetary policies. Furthermore, should companies suddenly find themselves unable to refinance debt, or - worse - rollover debt maturities, would lead to a wave of corporate defaults that starts at the lowest level of the capital structure and moves its way up, impacting such supposedly "safe" instrument as leveraged loans which in recent months have seen an explosion in issuance due to investor demand for higher yields.
To be sure, this transition will not happen overnight, but it will happen eventually and it will start with the riskiest companies.
To that end, Goldman has created a watch list for those companies that are most at risk: the ones with a credit rating of BBB or lower that are paying low average interest rates (less than 5%), have limited interest coverage (EBIT/Interest of <5x) and high leverage (Net Debt/EBITDA>2.5x) based on 2019 estimates; the screen is also limited to companies where Net Debt is a substantial portion of Enterprise value (30% or higher). The screen is hardly exhaustive and Goldman admits that "there are much more highly levered companies out there that could be more exposed to a turn in the cycle." However, the bank focuses on this subset given the low current interest cost relative to the risk-free rate, "suggesting investors could be complacent around their financing costs."
In other words, investors who are exposed to debt in the following names may want to reasses if holding such risk is prudent in a time when, for the first time in a decade, the average interest expense is expected to tick higher.