There has been a lot of talk about corporate bond risk lately in the official and unofficial financial media and I want to address some of the FUD (fear, uncertainty and doubt) that is being spread out there. Most of the FUD comes from hedge funders with online media channels and having worked at a couple of fund-of-funds (companies that invest in hedge funds and are effectively the bosses of hedge fund managers), I can tell you that part of any classic hedge fund operation is spreading bad rumors about good assets in an attempt to acquire those assets at a cheaper price and higher yield. Spreading FUD is an essential part of the game in finance. That doesn’t mean that all FUD is illegitimate, but very often FUD is being spread to trigger panics and get counterparties to sell good assets on the cheap. In 2019, this FUD game is taken to the next level by hedge funders who have their own media channels in which they can do long-form video pieces with which to scare a much larger group of investors quicker and more effectively.
The particular FUD I want to address here is the “Doom Loop” thesis by Raoul Pal which stipulates that we will have a cataclysmic event in the corporate bond sector and people should sell their corporate bonds now and run for cover (buy US treasury bonds) because the entire financial system will collapse. Raoul has a number of videos on his channel enlisting various financial industry experts that work towards convincing investors of this “Doom Loop” speculative thesis. In particular, the videos tend to prey on the general investor’s lack of knowledge of the corporate bond market. Most investors know stocks, but they don’t know bonds because they can be somewhat confusing. Thus with a combination of fancy jargon and biased experts, the spreading of FUD among retail investors can be particularly effective. I am writing this post to debunk Raoul Pal’s “Doom Loop” corporate bond thesis.
Corporate Bond Primer
To start with, I want to provide a brief introduction to the corporate bond market. A corporation is a group of people who got together to make money. A corporation has assets and liabilities. Assets are property and wealth the corporation accumulates while doing business. Liabilities are what the corporation owns to its lenders and owners. The liabilities of a corporation are either debt or equity. Debt is an obligation to make regular small payments of principal and interest in exchange for the corporation getting a chunk of money. Equity is what is left over from the corporate assets once all the debt is paid.
Generally speaking, Corporate Debt comes in 2 forms – Secured Debt and Unsecured Debt. Secured Debt is backed by actual tangible assets of the corporation such as property, plants and equipment. Unsecured debt is backed by the operating activities of the corporation (its revenues and profits). In the investment world, Secured Debt is usually referred to as “Investment Grade” debt and the widest and most popular ETF that invests in investment grade debt is LQD (iShares iBoxx Investment Grade Corporate Bond ETF). Unsecured Debt (or sometimes called subordinated debt) is generally referred to as “Junk” debt. The widest and most popular Junk Debt ETFs are HYG (isShares iBoxx High Yield Corporate Bond ETF). Junk debt is not backed by tangible assets but by the revenues and profits of certain corporate divisions or ventures. Thus junk bond debt is more risky and the successful repayment of it is subject to business conditions. Generally speaking, investment grade bonds pay higher interest than risk free obligations (US Treasuries) of a similar duration (time to expiration) to account for the ability of the corporation to pay back these obligations (credit risk) and the potential decline in the value of tangible assets. Junk bond interest rates are even higher than investment grade bonds to account for business cycle risk. When a company defaults (can’t make a payment on its bonds), its assets are sold off and secured bank loans are paid off first. If there is anything left over unsecured bank loans are paid next. If there is anything left over after that stock holders get the remainder. Generally speaking in a bankruptcy, shareholders are left with nothing.
The Equity part of the capital structure is split into two parts – Preferred Stock and Common Stock. Preferred Stock promises fixed dividend like a bond but also represents a claim on corporate profits. Thus the value of preferred stock can go up like common stock if business is good. Common Stock doesn’t promise guaranteed dividend payments and its dividends are only backed by the profits of the company – what is left over after all expenses (which include interest expenses on bonds) and taxes are paid. If a company defaults that is usually because it doesn’t have profits to meet its debt obligations. In that scenario, there is no money left for equity shareholders. From a credit risk perspective, stocks are the lowest on the risk ladder (most risky) while investment grade bonds are at the top (least risky) as you can see on the Capital Structure chart above. Institutional investors such as pension funds tend to dominate the safe Secured Debt market (investment grade bonds), retail investors tend to hang out in the risky Common Stock market, while Big Bank Merchant Bank units and Private Equity shops tend to dominate the money making Mezzanine Debt market (Junk Bonds and Preferred Stock).
Some Basic Facts about US Corporate Bond Market
The US financial system is rather large and US Corporate Bond market is one of its parts. Broadly speaking the US financial system is comprised of government revenues and debt, individual savings and debt and business equity and debt. Government debt is about $20 trillion in US Federal, State and Local Government Debt (Treasury Bonds and Municipal Bonds). That government debt is secured by about 3 trillion in income taxes/government revenues being extracted from a 21 trillion US economy and a 4 trillion FED balance sheet. And obviously by the ability of the FED to print money if necessary. On the individual side, US citizens have about 10 trillion in savings and about 10 trillion in mortgage debt secured by their homes. On the business side, we have roughly 25 trillion stock market representing business equity and 10 trillion corporate bond market. So broadly speaking US corporate debt is about 12% of the US financial system (10 trillion / 82 trillion)
Is Corporate Debt Really a Problem?
In their first Financial Stability Report in 2019, the FED highlighted the large amounts of corporate bonds as a potential downside amplifier in an economic downturn. Some FED presidents like Kaplan and Rosenberg have mentioned this risk in their speeches and FED chairman Powell has mentioned it in his press conferences. In particular, they point to the historically high Business Sector Credit-to-GDP ratio and the high issuance of leveraged loans (usually secured loans) as a concern. Notice, that junk bond issuance isn’t flagged anywhere as a concern as the junk bond issuance has been negative in recent years. But while noting the large amounts of debt, the FED makes sure to point out that companies are well capable of paying it. The FED notes the low default rates for leveraged loans which are very close to zero at present. They also point out that interest expense ratios are about 10% and about 18% for “risky” firms. Interest expense ratio is the amount of interest expenses versus operating profits (earnings before interest and taxes). Note that current interest expense ratios are at their lowest levels in history. Far lower than 2000 Dot Com Bubble era levels and lower than 2008 Financial Crisis levels!
Let’s dig into that Interest Expense Ratio number for the S&P 500 (SPX). Yardeni calculates after-tax interest expense as roughly $19 per share. In 2018, the SPX had a $132 in GAAP (after tax reported) earnings per share. The S&P 500 interest expense ratio is thus $19 / $132, equal to about 15% – right in line with what the FED considers “risky” firms. Before S&P 500 companies start skipping their debt interest payments, they first have to declare zero after tax profits. If you look at the chart below, even in 2008 during the Financial Crisis, the SPX still registered positive GAAP earnings. I am pretty bearish on US corporate earnings in coming years due to a combination of factors – higher wages, higher input costs, higher corporate taxes, higher tariffs due to deglobalization trends, higher interest rates, lower goodwill, all working in concert to reduce corporate profit margins which are currently at a record. The US society doesn’t owe corporations a high profit margin. I don’t want to go into much earnings doomsday detail here because declining earnings is not necessarily an economic negative, but I can definitely see a scenario where SPX profits get cut in half (from $132 to $65 per share) in 2021 or 2022 if we get a more pro-Labor government in the US.
As you can see from the chart above, buybacks and dividends is what corporate profits are spent on these days. Capital expenditures are usually financed with secured debt – investment grade bonds. If there are big profits, you have big buybacks and dividends. If corporate profits decline, first go the buybacks which will severely hurt stock multiples and then go the dividends which will be the 2nd punch in the gut for common stock holders. While I am certainly bearish on stocks, I certainly don’t foresee a scenario where SPX GAAP earnings go negative for a full year. In other words, the bar for a massive system wide collapse of the US Corporate Bond market is EXTREMELY HIGH. And that is why I think Raoul Pal’s Doom Loop scenario for US corporate bonds is complete and utter nonsense.
To Play Defense Replace Stocks with Corporate Bonds
I would like to share with you some default numbers for Junk Bonds, the riskiest form of Corporate Debt. The average annual junk bond default rate is 2.9%. However, when companies default the game is not over. Bond investors go into bankruptcy court and sell off the corporate assets and try to reclaim their money back. Principal recovery rate averages about 41%. On average, the annual junk bond loss given default is about 1.7% (default rate * principal loss rate). In many years, it is far less than 1%. The worst ever year for junk bond defaults was 2009 when the Loss Given Default rate was 8%. So think about that for a second: when stocks got cut in half (-50%) during the biggest financial crisis of our generation, the most you lost in junk bonds (the riskiest form of corporate debt!) was -8% if you held through to expiration. Given the mayhem that happened in 2008, I call this a walk in the park! Certainly, no “Doom Loop”.
There are plenty of reasons to be concerned about the global economy and about high levels of corporate profitability. There are plenty of reasons to be worried whether high corporate buyback and dividend levels can be sustained. There are plenty of reasons to be concerned about the stock market. However, to be concerned that big US corporations which employ the smartest and hardest working people in the country will NOT be able to make their debt service obligations which amount to only 15% of their current profits strikes me as complete nonsense. Particularly with a US government and a Federal Reserve Bank which recognizes the importance of a healthy private sector and accommodative liquidity conditions. What is a scenario where a big corporation like Apple will be selling off its brand new campus for 10 cents on the dollar because its bonds are in default? World War 3? If that happens, your corporate bond exposure will be the least of your problems. Investing in American corporate bonds is just as patriotic of an investment in American enterprise as investing in stocks. And before recessions, it is the smarter way to make a bet on America!
I am worried about the US Stock Market. But I am not worried about the US Corporate Bond market. Not in the least bit. Broad Junk Bonds ETFs like HYG pay about 5% in annual interest. Investment Grade ETFs like LQD pay 3% interest. If you want to bulletproof your balance 60/40 stock/bond portfolio for a recession/weaker economy given the high valuations of common stocks, you replace the 60% in SPY with 20% in HYG (junk bonds) and 20% in LQD (corporate bonds). Then you put 20% either in Gold (GLD) if interest rates are rising because of stagnation and inflation (stagflation) or Long Duration Treasuries (TLT) if interest rates are declining because of recession and deflation. Either way, you are cranking out 3-4% interest and your wealth is keeping up with inflation. If inflation is stronger, Gold is a good hedge for your bond principal. If deflation and recession sets in, Long Duration Treasuries are a good hedge for your bond principal (because Long Duration Treasuries tend to gain via capital appreciation when rates go down to zero). Either way, you are ready to ride out either form of economic turbulence like a champ with nice monthly payments until stock valuations become more reasonable. And once stocks get cut in half, guess what? You will have the money to step in and take on risk. Don’t fear the Doom Loop. Take advantage of it like Raoul Pal!