Corporate Debt Gone Wild

Tue, Mar 3, 2020 - 1:23pm

Public and private debt levels are at all-time highs, and with stocks seeing their worst week since 2008, many are wondering what excess debt means for the future. To understand how private debt is likely to handle a downturn or recession, Financial Sense Newshour turned to Financial Sense Wealth Management’s CIO Chris Puplava, who relies on fundamental analysis and unbiased research to inform his analysis.

For audio, see We're Due for a Correction, Says Ralph Acampora.

Corporate Debt's Red Flags

Corporate debt levels are raising a red flag right now. The U.S. corporate investment grade bond market has deteriorated significantly in terms of bond quality over the last few years. In the early 1990s, the average corporate bond rating was not BBB, (the lowest investment grade rating). A-quality bonds were closer to the average, with the highest rating at AAA. Over the past three decades, average bond quality in the investment grade corporate bond market deteriorated to the point where half of the entire U.S. corporate debt market is rated BBB— only one notch above junk status.

Puplava said another economic recession is inevitable, thanks to a business cycle that has yet to have been repealed. When this recession does happen, the poor quality of corporate debt could create several problems for investors. In such a downturn, Puplava explained, corporate revenue will decline thus reducing their ability to service debt. Before that happens, we are likely to see interest rates for corporate debt begin to move up relative to Treasuries, which means the cost of financing debt is more expensive.

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“There is a tremendous amount of corporate debt that is maturing in the next two to three years,” Puplava said. “If this debt matures at a point where it has to be refinanced with new debt at higher interest rates or at a time that we're in the midst of a recession, there are going to be some problems. Investors need to pay attention and understand what they own to know when to sidestep the investment-grade market and either go to cash or Treasuries.”

From Investment Grade to Junk Bonds

The distinction between investment grade and junk bonds is arbitrary, Puplava said. Many insurance companies, pensions and foundations have an investment mandate prohibiting them from owning junk bonds, which are those rated BB or lower. Consider historical default probabilities, the risk of default does not materially increase going from BBB, which is the lowest tier of investment grade bonds, to BB plus, which is the highest tier for junk status. Bloomberg’s historical default data shows the lowest tier of investment grade bonds have a one-year default probability of 0.3% to 0.52%.

Going to junk status, that default probability only moves up marginally from 0.5% to about 0.9%, Puplava explained. This highlights the arbitrary nature of the prohibition as there is not much difference in the material risk of default between the highest quality of junk bonds versus BBB bonds.

“When a bond gets downgraded to junk status, there is a wave of selling. … We’ve seen Kraft Food Heinz downgraded to junk status and that's a consumer staple. It might come as a surprise that they are now considered a junk bond issuer. Macy's was also downgraded to junk status recently. The biggest issue is being stuck with an investment-grade bond or a bond fund and you start to see a wave of downgrades, which I believe will happen in the next downturn,” Puplava said.

Rating the Ratings Agencies

While there are many rating agencies, such as Moody’s and Standard and Poor’s, Puplava explained that Financial Sense Wealth Management only uses Bloomberg’s rating system. Agencies such as the two above can be prone to conflicts of interest as bond issuers and others shop for rates.

Puplava believes Bloomberg’s service is more objective and provides real-time information. While some ratings agencies have been slow to upgrade or downgrade a rating, Bloomberg’s model is updated in real time and is based on stock price data, key financial metrics and what insurance markets are saying. This market level and balance sheet data is updated daily. In contrast, the more well-known ratings agencies will not issue an upgrade or downgrade on a rating unless there is a material change or new issue coming to market.

“That's the risk of relying solely on Moody's and Standard and Poor’s. There could be huge delays in the rating’s changes issued by those issuers versus Bloomberg, which is updated daily. The question is, why aren't these being rated junk right now? Part of that is that inherent conflict of interest … You don't have that issue when it comes to Bloomberg's ratings. They’re not rating companies and getting a fee for it. … You’ll get an early warning with those questionable bonds that rating agencies are loath to downgrade for losing business.”

To listen to this podcast see We're Due for a Correction, Says Ralph Acampora, or for a full archive of past shows, visit our Financial Sense Newshour page.

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