- Andrew Ross Sorkin
“No man’s credit is as good as his money.” - John Dewey
Early this summer I wrote about debt and the Russell 2000 (“Where Are the Prisoners? Debt and the Russell 2000”. The article can be found here.) In the article I discussed Stanley Druckenmiller’s comments that pointed out two salient points. First, debt in the Russell 2000 was growing far faster than profits (debt grew by 65% from 2010-2018 while profits grew by 29% in the same period). Second, between 2010-2018, stock buybacks ($5.7T) far exceeded capital expenditures ($2.2T). This is a complete reversal of the last 35 years which averaged buybacks (20%) versus capex (80%). I also wrote about the changing structure of corporate debt in “Fata Morgana and the Illusion of Safety” (which can be found here). In that article, I write about the explosion in “covenant-lite” loans (essentially debt requiring little or no collateral as well as little to no documentation) from less than 5% of total leveraged loans to roughly 75% today.
I bring this up again as there was a great discussion which took place at the Morningstar Investment Conference earlier this year in Chicago. In an article and transcript of a panel conversation (“Rates, Spreads, and Credits”, Morningstar Magazine, Fall 2019, page 56), there was a great discussion about the changes in both the debt being issued (quality, etc.) as well as the form it is being invested in by the markets (cov-lite, etc.). Combined with my earlier discussion, I think it is wise for all investors - institutional or individual - to take a closer look at and how it might impact both the overall markets, individual portfolios, and sovereign economies.
The Changing Face of Debt
We know that each new financial crisis is a pale cousin of the last, though - as Andrew Ross Sorkin wisely states - there is almost always a component based on leverage and excessive debt in the mix. Looking out over the debt markets, its seems some of the novel products or the move to passive indexing have completely upended the debt markets over the past two decades.
Credit Standards Have Dropped to Alarming Levels
At the Morningstar conference, it was pointed out that roughly one-half of all corporate debt is made up of BBB-rated quality (one notch above junk status). According to Morningstar, the composition of a US Core Bond Index fund has seen its credit quality drop from A in 2008 to A- in 2018. BBB credits as a percent of corporate market value (meaning what percent of total corporate debt) has risen from 27.8% in 2008 to 48.9% at year-end 2018. Additionally, (and perhaps more frightening) the percent of BBB credits that make up the total market value of the index has risen from 9.2% in 2008 to 19.1% at year-end 2018. This means that the individual investor has seen their typical core bond index fund double its share of BBB credits - just one notch short of junk status - over the last decade. One can only imagine what type of returns an investor might see should they find themselves in a 2007-2009 credit crisis again.
What We Mean by “Core” Has Changed A Lot
In 2008, government debt made up roughly 31% of a core index bond fund. By year end 2018 that number had increased to 42%. A real change was agency debt. This has dropped from 7.5% in 2008 to just 1.3% in 2018. The largest change - in percentages and dollars - was the decrease in mortgage-backed securities. This was the debt that played a critical role in the US housing market bubble and the subsequent crash. This debt went from 43% of the US core bond index in 2008 to just 29% at year-end 2018. All of these changes have fundamentally changed what investors have in their portfolio when they invest in a “core” bond index fund. Combined with the changes discussed earlier in corporate credit quality, investors are looking at a substantially riskier product.
Rates are Increasingly Volatile in Nature
Since authoring my articles about corporate debt roughly 5 months ago, we have seen some extraordinary changes in the bond markets. The US treasury yield has inverted, the Chinese/US trade conflict has moved closer to a trade war, the President of the United States is threatening the Chairman of the Federal Reserve and calling him “clueless”, and over $15 trillion (with a “T”) of global sovereign debt has a negative yield. We also see the UK careening towards a completely Wild West Brexit, several of the world’s largest economies teetering on the edge of recession, and Hong Kong simmering on the brink of revolt against mainland China oversight. How to navigate these waters and find security in the bond markets is becoming increasingly hazardous.
Passive Indexing Has Affected Bond Market Liquidity
The ability to connect a buyer and seller (or market liquidity) - even during times of market difficulties - is essential to maintain asset prices. When liquidity breaks down, investors can begin to see distortions in pricing. Until 2008, the largest bond brokers warehoused bonds assuring there was adequate liquidity and seamless trading in the debt markets. In 2018, that model is nearly completely gone. For instance, in 2007, there was roughly $7T in outstanding corporate debt. Dealer inventories were roughly $250B. By 2018, this had changed dramatically. At year end, there was roughly $10T in outstanding corporate debt (an increase of 43% between 2007 - 2018) but dealer inventories had dropped $12B (a decrease of 95% between 2007 - 2018). This collapse in inventories will create an enormous crimp on liquidity should we face another credit crisis similar to 2007-2008.
What This Means
For individual or institutional value investors managing portfolios heavily tilted to equities, this whole conversation about the evolution of the debt markets may seem beyond their interest or investment scope. I would hasten to remind portfolio managers who saw no connection between mortgage-backed securities and the S&P 500 to reflect back on those “halcyon” days of late 2007 through 2008 when most major stock indexes dropped 35-40%. The bond markets act as the lungs to the greater asset markets ranging from equity indexes to venture capital. When the lungs stop breathing, it’s safe to say it catches most peoples’ attention. It has in every other crisis and the next one will be no different.
As an institutional investor, I have a fiduciary responsibility to my investment partners to prevent the permanent impairment of their capital. Whether that is a portfolio made up of 95% equities with a 100 year time horizon, or one made up of 90% bonds paying for a planned 15 year retirement, the bond (and credit) markets can make and break returns. Bearing that in mind, here are a few rules which I try to live by in this wildly fluctuating market.
Cash Is Still King
As John Dewey points out, no man’s credit is as good as his money. Regardless of how secure you think debt may be, it’s still not better than cash. Even US Treasuries - considered the safest investment in the world - can be dramatically impacted when the President of the United States suggests we could simply renegotiate our debt at will. It could also equally be affected by Congress simply not increasing the United States government’s debt limit. While running from the risk of inflation or lost opportunity costs, the holding of cash is sometimes the best of a bad lot.
Debt is Never Stagnant in Price or Value
Unless the investor intends to purchase debt at par and hold for its duration or until it is called (while still running the risk of default), the pressures of inflation, the Federal funds rate, currency exchange, etc. can make bonds surprisingly fluid in their valuations. As one looks at the changes in a US core bond index fund, you can see dramatic changes in risk and uncertainty in just the past 10 years. Always remember that bond pricing - and valuation - is not stagnant. One can overpay or suffer permanent capital impairment in bonds just as easily as equities.
Valuation and Risk Assessment is Vital
Just as a good value investor will look at the act of equity investing as purchasing a part of a business, investing in debt is no different. Though you might be higher on the bankruptcy totem pole, this doesn’t assure you of a positive return. Much the same as purchasing a stock, an investor should spend a considerable amount of time studying the company’s financial statements, competition, markets, etc. Significant focus should be on the ability of the company to meet current and future debt servicing requirements.
The debt markets are a foreign concept to many value investors. For most, a simple bond index fund or ETF will take care of any bond coverage they feel they need. It’s rare to hear individual or institutional value investors discussing the purchase of individual bonds. Because of that, it’s even more important to understand the general debt markets, their trends, their risks, and what story they are telling us at the moment. At Nintai we have an almost unhealthy focus on risk mitigation. Every day we ask what market data can warn us of risk and uncertainty in the markets. Right now the debt markets are telling us that markets are - in general - overpriced, the risk of both a US and global slowdown is higher than appreciated, and that cheap debt is at risk of rate fluctuation or slowing growth. Those messages - taken in context with our portfolio positioning - means we are prudent in our assessment of debt carried by our holding companies, ruthless in credit quality requirements, and we maintain large cash positions.
As always I look forward to your thoughts and comments.