InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
JUNE 20, 2018
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We have been Looking Ahead to the problems waiting over the horizon for the U.S. Economy. After the currently-frothy markets play out … probably by the end of this year … complications await, in 2019 and thereafter.
We have warned of the prospects for Stagflation, perhaps as soon as 2020; and, discussed the evolution of Credit Cycles in the transformation of world economies. This week and next, the subject will be Debt … its many forms, and its impact on our economic well-being.
Credit Cycles
Our discourse on Credit Cycles revealed a fundamental change in economic cycles, attributable to central bankers, particularly the U.S. Federal Reserve (The Fed). Over the last 20 years, American companies and individuals have learned from The Fed that running up Debt is easy and fun!
Unfortunately, Debt eventually becomes a drag on growth. Debt-induced growth pulls spending forward, reducing a future recovery. Debt also artificially boosts asset prices.
The repercussions from the Credit Cycle of the last 20 years include a massive increase in Debt … by the federal government, by many U.S. corporations, and by millions of individual Americans. The ratio of Debt to gross domestic product is at record levels.
This environment sets up the American economy for financial instability.
Financial Instability Hypothesis
Professor Hyman Minsky of Bard College published his Working Paper on the Financial Instability Hypothesis in 1992. His basic point: that over-exuberant companies become paralyzed when they take on too much Debt, and this leads to a financial breakdown.
The hypothesis was clearly illustrated in 2008, when overexposure to subprime mortgages and their associated derivatives led to a breakdown in the banking systems, which almost brought down the U.S. economy.
Today, there is a much greater risk of financial crisis on the horizon because of the sheer amount of corporate debt now outstanding, especially high-yield bonds which will be difficult liquidate in a crisis.
Illusion of Liquidity
Economist Louis Gave recently published an article titled, “The Illusion of Liquidity and Its Consequences.” In his research, he looked at corporate bond ETFs and compared the total Dollar amounts to the inventories of trading desks … this is a rough measure of liquidity.
Gave found that dealer inventories are not remotely sufficient to accommodate the bond-selling expected as interest rates rise. The bond market has doubled in size in recent years, while the willingness and ability of bond dealers to provide liquidity under market stress has fallen by more than -80% in the same period.
Here is a likely scenario: as interest rates rise, the value of bonds in mutual funds and ETFs falls. The investors … often regular Americans and retirees seeking yield … all try to sell at once. The funds must meet these redemptions, so they will sell at whatever prices are available. In a bear market, you sell what you can.
Speaking of the investors, much of the Two Trillion Dollars currently invested in bond mutual funds and ETFs are NOT owned by “traditional” long-term investors in bonds, who would often hold the bonds until maturity. Therefore, when bonds start to fall, there will be thousands of demands for redemption.
The funds may find that there will be no bids for the lesser bonds in their portfolios, so they will have to sell the best bonds in order to meet redemptions. Remaining investors will be stuck with increasingly poor-quality portfolios, which will lose value even faster
The word “calamity” may not be too strong in describing the markets then.
Making matters worse, many lenders are now more highly leveraged than they were ten years ago. Many have bought their corporate bonds with borrowed money, confident that low interest rates and low defaults would keep risks manageable.
According to S&P Global Market Watch, 77% of leveraged corporate bonds are “covenant-lite,” meaning that the borrower (issuer of the bond) doesn’t have to repay by conventional means. Sometimes, they can even force the lenders to take more debt.
Buying such bonds may have been a good idea at the time … what happens when the times get tough?
Rolling Over the Debt
According to Wells Fargo Securities, Four Trillion Dollars of corporate bonds in the U.S. must be refinanced over the next five years. This amounts to over 65% of all outstanding corporate debt in this country
As interest rates rise, that Debt becomes more expensive to extend. Many companies will lose the ability to service their debt.
Investors would be justifiably concerned. Combine unprecedented amounts of borrowing with interest rates rising steadily, and corporate balance sheets approach a
tipping point.
When companies can no longer service their Debt, they have to cut back. They will do so by laying off workers, reducing inventory and investment, or selling assets. All of these actions reduce growth. If reductions spread across the country, we get economic contraction, and Recession ensues.
More on Debt next week.