The above quote comes from a WolfStreet article recapping Clover Technology’s leveraged-loan blow-up last month. A private equity-owned recycler of cell phones and inkjet cartridges, Clover had lost two key customers, a fact it did not have to share with creditors until the eleventh hour because the loan was covenant-lite. By the time Clover broke the news, it had already hired advisors in preparation for debt restructuring or bankruptcy. Investors rushed to unload Clover's debt—which totaled $693 million—only to run into a liquidity trap. Clover’s price chart illustrates what happened next:
For more than a year, we have dissected the systemic threat posed by record corporate debt (see WILTWs May 24, 2018, September 27, 2018, and December 6, 2018). Corporate debt quantity continues to increase as debt quality deteriorates. As of 1Q19, U.S. nonfinancial corporate debt stood at a record $9.92 trillion and nearly one-third of that debt is either below investment grade or leveraged loans. Roughly 14% of firms in the S&P 1500 are now zombies, meaning they do not have enough earnings before interest and taxes to cover interest expenses.
Yet, despite intensifying risk, yield-starved investors continue to funnel funds into U.S. corporate debt. In 1Q19, taxable-bond funds saw nearly $102 billion in inflows, according to Morningstar data. The illusion of “daily liquidity” offered by mutual and exchange traded funds has transformed bond investing. According to a recent report by the Bank of England, roughly $30 trillion of global funds “offer short-term redemptions while investing in longer-dated and potentially illiquid assets, such as corporate bonds.” Large sums invested under false pretenses in high-risk assets has always been the recipe for financial crises.
The Fed reversing course and lowering rates has allayed the concerns of many. That complacency is misguided. Clover Technologies sent a loud and clear message: corporate fundamentals, not just interest rates, matter. If the global economy continues to deteriorate as protectionism escalates and over-indebted companies lose business, they will be faced with two choices: deleverage or default.
In a report released at the end of last month, Goldman Sachs analysts published a chart that should be top-of-mind for every investor:
Over the past year, nonfinancial companies in the S&P 500 have seen cash levels decline 15%, the largest drop since at least 1980. Meanwhile, gross debt outstanding for S&P 500 companies has risen 8% over the same period.
Burdened by tariffs and slowing global growth, companies have poured money into buybacks in order to sustain equity values. In the 12 months ended March 31, S&P 500 firms spent 103.8% of their free cash flow on buybacks and dividends, which comes after spending 101.9% in 4Q18. It is the first time since before the Global Financial Crisis (GFC) that S&P 500 payouts have exceeded cash earned.
Goldman’s chart is testament to the unsustainability of current market conditions. Firms will inevitably have two options if profitability continues to deteriorate: Buybacks have to slow dramatically so firms have the necessary cash to pay down their debt loads, which would cripple a U.S. equity market that has become unprecedentedly dependent on buybacks. Or they’ll face defaults and junk downgrades, which could cause panic in bond markets as risk gets properly priced. The amount of debt in the BBB range—one rung above junk—now sits at roughly $2.8 trillion, or more than half the U.S. high-grade universe.
The global spike in negative-yielding debt is a clear reason why demand for U.S. corporate debt has remained high. According to a report last month by Schroders, U.S. corporate debt returned over 4% in the three months ended in June, compared with 3.1% in government bonds. Meanwhile, as Deutsche Bank’s Torsten Slok noted recently: “Excluding US Treasuries, US corporate bonds, MBS, CMBS, and ABS shows that 43% of the global ex-US IG index is trading at negative yields at the moment, up from 20% late last year” (chart below). This week, negative yielding debt reached nearly $15 trillion globally.
Roughly 40% of new large leveraged loans issued in 1Q19 left companies with debt six or more times greater than Ebitda. That’s up from 30% for all of 2018, which was the highest full-year percentage since 2001. Moreover, as Bloomberg noted this week: “High-yield issuance recorded the busiest July in five years with $23.5 billion priced, and CCC rated debt accounted for the highest proportion of issuance since February.”
In May, risk premiums on investment-grade bonds sat at just 1.09% over Treasuries, near the lowest levels since the GFC. And in July, the spread between BBB and BB bonds dropped to a 12-year low, according to Morgan Stanley. When yields decline, investors are more likely to flee at the first sign of trouble.
Earlier this year, we dissected how the sell-off last December offered a glimpse at the liquidity threat building in corporate debt markets (see WILTW January 31, 2019). As Guggenheim’s CIO Scott Minerd told Bloomberg: “What was really amazing to me was how crowded and congested the exits got when people started moving in that direction…You wanted to adjust the risk based upon the volatility…you couldn’t get good prices.”
Evidence continues to mount that the liquidity threat is intensifying. As Bank of America Merrill Lynch detailed in a “high yield roundup report” released early last month (recapped here by MarketWatch):
The team…tracked outflows of $7.1 billion to high-yield funds between May 26 and June 7, which resulted in about a 110 basis point widening. When another $6.6 billion flowed back into the fund in early June, spreads narrowed 70 basis points…BAML analysts in the high-yield market summary characterized the volume of flows as “an amount that should not matter” to a market that trades $10 billion on an average day…“The steep price of liquidity was on full display in recent months.”
Exacerbating the liquidity threat, banks have been forced to retreat from their traditional market making role by post-GFC regulations. The Financial Times recently encapsulated the implications of this for the bond market:
Put simply, traditional market makers for fixed-income products cannot now warehouse risk…[US investment grade credit] grew by 43% between 2007 and 2018, while dealer inventories were just 6% of what they were in 2007…The new generation of intermediaries connects buyers and sellers only when two-way interest exists, and this can be sporadic.
This fragile liquidity balance will soon be tested. For one, the biggest U.S. high-yield bond ETF—iShares iBoxx High Yield Corporate Bond ETF—saw its biggest outflows of the year last week, with $2.6 billion withdrawn. Then on Monday, the spread between U.S. junk bond yields and government debt had its largest single-day move in three years, jumping 34 basis points. As global economic uncertainty intensifies, bond market volatility will intensify.
For another, with the suspension of the debt ceiling, the U.S. Treasury has announced plans to rebuild its cash balance from $133 billion to $350 billion, which will suck significant liquidity out of the broader financial system. In the QE era, the Fed has replaced banks as the primary liquidity provider for markets. Even with the Fed lowering rates, a flood of new UST supply could “pressure funding markets” and “challenge Fed policy control”, as Bank of America Merrill Lynch warned this week.