InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
JUNE 27, 2018
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
We continue our discussion of the problems for the U.S. Economy in the near future. For this week and next (and probably the following week), the subject will be Debt … its many forms, and its impact on our economic well-being.
Our responsibility … to our clients, colleagues, and friends … is to reveal the myriad ways that Debt creates complications for our economy.
As we noted last week, Debt has been much too easy to amass over the last 20 years. It has artificially boosted asset prices, and will become a serious drag on growth in the near future.
Making matters worse, many lenders (investors) 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.
Covenant Quality
Last week, we touched on the subject of Covenants in the context of Bonds. Remember that investment Bonds are Debt instruments. Covenants are the basic rules which govern the agreement between borrower and lender with respect to various Debt instruments, such as Bonds and Loans. Covenants enforce the requirements of the issuer … what the company can do (positive covenants), and what it cannot do (negative covenants).
A common example, with respect to a Corporate Bond, is the “restricted payments covenant.” This provision protects the lender (investor) by limiting the company’s ability to make distributions and asset transfers which would hinder the borrower’s ability to repay the debt. This can include restrictions on stock repurchases, prepaying junior debt, and dividends. Other covenants may require certain debt-to-assets or interest coverage ratios.
Over the past few years, Covenant Quality has declined dramatically with respect to leveraged loans. Leveraged loans are loans issued by companies with below-investment-grade ratings. Traditionally, these loans have featured a number of Covenants intended to protect the lender/investor. On the other hand, a “covenant-lite” loan has fewer restrictions, therefore more risk.
U.S. corporations and investors obviously have very short memories. Just 10 years after the most severe financial crisis since the Great Depression, Americans are taking on record amounts of risk, in the form of “covenant-lite” leveraged loans. Featuring fewer covenants … and weaker covenants … this form of Debt allows the borrowing company to favor its own agenda and shareholders, to the detriment of holders of its Bonds.
Today, 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.
U.S. “covenant-lite” loan issues for 2017 were the highest in over a decade, a record $677 Billion. This was almost double the $350 Billion in the previous year. By comparison, the amount in 2007 was $150 Billion.
So far in 2018, American corporations are on pace to issue over $600 Billion in new “covenant-lite” Debt.
When the Credit Cycle turns over, Declining Covenant Quality will make things very difficult in the Bond space. With interest rates continuing to rise, corporate borrowers will find it more and more difficult to pay off their Debt.
Because of the massive amount of Debt which has been amassed over a prolonged period of ultra-low interest rates, Corporate Bond Defaults will be the inevitable result.
A Looming Corporate Debt Crisis
As rates rise, government bonds will become a viable alternative to other assets again. If an investor can earn an adequate return in a risk-free Treasury, riskier stocks and corporate bonds will become relatively less attractive. H igher interest rates create a stronger and stronger headwind for other assets.
The ultra-low interest rate regime of the last decade … created by the Federal Reserve and other central bankers … allowed thousands of companies to borrow money, including many which would have gone bankrupt without the infusion of “cheap loans.” There are now several hundred publicly-traded corporations which will NOT be able to repay their debts in the coming crisis.
Several hundred American companies are destined for bankruptcy in the near future.
Consequences of the Debt Crisis
Here is a brief outline of the likely order of events in the Great Unraveling of the next few years:
Illiquidity will spread as lower-end corporate bonds fall to junk ratings. Then, legal and contractual constraints will force institutions to sell, pressuring all but the highest-grade corporate and sovereign bonds.
Go back to our discussion of the Credit Cycle in the June 13 issue of IntelDigest. Instead of recession pushing asset prices lower, lower asset prices trigger the recession. That will be the next stage as falling stock and bond prices hit borrowers.
Rising defaults will force banks to reduce their lending exposure, drying up capital for previously creditworthy businesses. This will put pressure on earnings and reduce economic activity. Recession will follow … here, and around the world.
As always, a U.S. recession will spark higher federal spending and reduce tax revenue. The federal government deficit will quickly rise to $2 Trillion per year. Total federal Debt will reach $30 Trillion within four years.
Private capital markets will be constrained, and everyone will “enjoy” rising tax burdens.
American jobs will be endangered because of the massive amount of corporate Debt. As the weaker companies approach default, they will be desperate to cut costs. Cutting human workers and moving to more automation … this will be a likely strategy. Both manufacturing and service jobs are in jeopardy.
We will publish a new series on the prospects for the American Worker later this year.
More details on the coming Debt Crisis next week.