Silver as an investment

Rationalizing Peak-Cycle Numbers: Investors “Unconcerned” About Record Corporate Debt

Authored by John Rubino via DollarCollapse.com,

A branch of journalism that might be called, “don’t worry, be happy, because this time is different” tends to pop up at the peak of cycles when imbalances that caused past crashes start to reemerge. Eager to keep the gravy train going, business publications send reporters out to interview industry experts (who are making fortunes from the ongoing expansion) on why this batch of imbalances is actually no problem at all. And sure enough they find all kinds of plausible-sounding rationalizations.

In the 1990s dot-com bubble, for instance, stratospheric P/E ratios didn’t matter because for New Age tech companies earnings were “optional.” In the 2000s housing bubble record mortgage debt didn’t matter because home prices would always rise faster than the associated borrowing, keeping homeowners above water and banks ever-solvent. Subsequent events proved this to be nothing more than insiders trying to keep the deals flowing.

Now, with pretty much every major indicator signaling a peak for the latest cycle, “don’t worry, be happy” is once again a popular journalistic beat. Here’s an excerpt from yesterday’s Wall Street Journal on why investors fine with record corporate debt:

U.S. corporate debt has climbed to levels that have coincided with recent recessions. Many analysts and investors are unconcerned.

Even before this week’s blockbuster $40 billion bond sale by CVS Health, corporate debt stood at 45% of GDP, a level it last reached in 2008 as the economy was entering a recession, according to Moody’s Investors Service.

Some companies with weaker credit quality are finding it easier to access the bond market, and others are skimping on covenants protecting investors. Yet analysts say the differences between the current period and 2008 and 2001—when corporate debt rose to similar levels as the U.S. tipped toward contraction—are more important than any similarities.

Today, signs of economic growth persist, supported by corporate tax cuts and a simulative budget deal, as well as borrowing costs that remain relatively low by historical standards. That means companies can continue to borrow without creating significant economic risks, according to analysts.

Moody’s predicts the economy will grow 2.7% this year and expects the default rate on corporate bonds to drop to 2.2% by year-end from 3.2% in January.

Today’s credit conditions are also stronger than in the past because of larger capital buffers held by U.S. banks as part of more stringent regulatory standards, Moody’s analysts said.

Banks’ bondholdings have shrunk drastically since the financial crisis, in part because of Dodd-Frank banking reforms but also because investors are more willing to buy the securities they underwrite. This signals an improved capacity within the economy to handle the present level of corporate borrowing.

Banks formerly held significant amounts of bonds either as unsold inventory from or with their proprietary trading units. In January 2008, the bond dealers in the Federal Reserve’s network of primary dealers who underwrite the U.S. Treasury debt held as much as $279 billion of corporate debt on their balance sheets compared with $24 billion as of last month.

Corporations are in a better position to function with higher debt burdens than in the past, some analysts said.

“The difference this time is really in the debt affordability,” said Anne van Praagh, head of credit strategy & research at Moody’s Investors Service.

The yield on the 10-year Treasury note, which serves as a benchmark lending rate for companies, has climbed this year, recently hitting a multiyear high of 2.943%, compared with an average rate of 4.63% in 2007. And with credit spreads—the difference in yield between corporate bonds and Treasury debt—hovering near multiyear lows, investor demand continues to hold down borrowing costs for most companies.

One of the fun ways to read this kind of journalism is to count the sentences likely to come back to haunt the reporter and/or his source a few years hence. The above article has a ton of them, but here are three that stand out:

“Banks’ bondholdings have shrunk drastically since the financial crisis, in part because of Dodd-Frank banking reforms but also because investors are more willing to buy the securities they underwrite. This signals an improved capacity within the economy to handle the present level of corporate borrowing.”

If there are record amounts of corporate bonds in circulation and banks don’t own them, who does? Bond ETFs and pension funds, neither of which will react well to the next downturn. ETFs will see outflows which require them to sell existing positions, thus pushing prices down even further. Pension funds will fall into a black hole of underfunding if their current investments lose value when they’re supposed to rise by a steady 7% per year. Both ETFs and pension funds are every bit as fragile and systemically dangerous as big banks were prior to the Great Recession.

“The yield on the 10-year Treasury note, which serves as a benchmark lending rate for companies, has climbed this year, recently hitting a multiyear high of 2.943%, compared with an average rate of 4.63% in 2007. And with credit spreads—the difference in yield between corporate bonds and Treasury debt—hovering near multiyear lows, investor demand continues to hold down borrowing costs for most companies.”

To note that interest rates recently hit a multi-year high but brush that off because they’re still lower than past peaks is the kind of snapshot thinking that ignores trends. And in finance it’s really all about trends. If the 10-year Treasury rate keeps rising, corporate borrowing costs will have to follow – and will eventually spike when higher interest rates destabilize the economy. Put another way, it’s not the nominal interest rate that matters, it’s the resulting interest cost. And with the world approximately twice as indebted as it was a decade ago, a lower interest rate can still generate a debilitating level of interest expense.

“Today, signs of economic growth persist, supported by corporate tax cuts and a simulative budget deal, as well as borrowing costs that remain relatively low by historical standards. That means companies can continue to borrow without creating significant economic risks, according to analysts. Moody’s predicts the economy will grow 2.7% this year and expects the default rate on corporate bonds to drop to 2.2% by year-end from 3.2% in January.”

Growth is always robust and prospects bright – according to forecasters who get paid by companies and/or governments that benefit from positive perceptions – just before something blows up and stops the expansion. In 2006, everyone from Ben Bernanke to Goldman Sachs thought 2008 was going to be a great year.

So insouciant bondholders are just following the standard late-cycle script.