It started out kinda ‘Crazy,’ in 1961 to be exact. A 20-something-year-old bass player by the name of Willie Nelson had written a song which he generously offered up to country singer Billy Walker. Walker, however, perceived the lilting lyrics to be a bit too feminine, so he passed. The late Patsy Cline would be forever grateful to Willie for ‘Crazy,’ which she sultrily sang to stardom, and in doing so, founded a movement.
We’re familiar with what followed, from the hobo portrayed as ‘King of the Road’ to the petulant moment, ‘The day my momma socked it to the Harper Valley PTA.” Even the most vacuous pop music acolytes couldn’t help but to let Olivia Newton John know they loved her. Did they ever let her know! And who didn’t want to emulate Glenn Campbell? Even those 1975 disco divas velvet-roping at Studio 54 dreamed of landing the perfect Rhinestone Cowboy.
Year in and year out, Crossover Country hits made traitors of pop purists. Even Willie finally got his mainstream due, with 1982’s No. 5 pop chart hit, “Always on my Mind.” It wasn’t until 1983, when Dolly Parton & Kenny Rogers met on “Islands in the Stream,” taking the hit all the way to No. 1 on the charts, that crossover crossed back over to strictly Country terrain.
And now there is Sam Hunt. Never heard of him? Chances are you can recite a line or two from ‘Body Like a Back Road,’ Hunt’s Crossover Country megahit that recently landed at No. 6 on the Billboard 100. Even if you choose to be obtuse about what the song is about, you can’t help but roll the windows down and sing about “Doin’ 15 in a 30.”
That is, unless you’ve recently hit our country’s byways and all but screamed at that infuriating Sunday driver who only adheres to half the law, that is, doesn’t comprehend Slower Traffic Keep Right (!)
Unbeknownst to unassuming corporate bond holders, they too will soon be forced into the slow lane. For the moment, the vast majority fancy themselves that equally exasperating driver who won’t get out of the fast lane, determined to bully their way to their damned destination. As for the perils of tailgating, they’re for the other guy, the less agile driver with rubbery reflexes.
That’s all good and well and has been for many years. Bond market fender benders are nearly nonexistent. The question is: Will central bankers worldwide turn placid parkways into highways to hell as they ‘remove accommodation,’ to borrow from their gently genteel jargon? That’s certainly one way to interpret Federal Reserve Chair Janet Yellen’s latest promise to shrink the balance sheet ‘appreciably.’
Care for a translation? How easily does “Aggressive Quantitative Tightening” roll off the tongue? Perhaps you’ve just bitten yours instead.
Enter the International Monetary Fund (IMF), The Institute of International Finance (IIF), The Bank of International Settlements (BIS), and by the way, the Emerging Markets complex including and especially China.
As a former central banker, it is with embarrassing ease yours truly can bandy about fantastic figures. No surprise that nary an eyebrow was raised at the latest figures out of the IIF that aggregate global debt is closing in on $220 trillion, as touched on last week. Consider that to be the broad backdrop.
Now, narrow in on the IMF’s concerns that financial stability could be rocked by a rumble in US corporate debt markets. Using firms’ capacity to service their debts from current earnings as a simple and elegant yard stick, the report warned that one in ten firms are failing outright.
The last two years of levering up have exacted rapid damage: earnings have fallen to less than six times interest expense, this during an era of unprecedented low interest rates. And as record non-financial debt as a percentage of GDP quickly approaches 50 percent, the share of income required to service this mountain is at a seven-year high. Should financial conditions tighten (the report was published in April prior to the Fed’s June rate hike), one-in-five firms are likely to default, which rises to 22 percent if rates continue to rise.
A separate signal of distress flickers into focus when one considers the sectors most at risk. Add up energy, real estate and utilities and you get to about half of the at-risk debt. And we wonder why Boston Fed President Eric Rosengren is perturbed about commercial real estate (CRE) and the risks it poses to the banking system.
A few bullets on CRE:
- Smaller banks with less than $50 billion in assets hold $1.2 trillion of the $3.8 trillion in outstanding CRE debt. Larger banks are relatively less exposed, with $767 billion. This begs the question why the Fed chose this year to not stress test the smaller banks?
- Bank holdings of CRE have risen nine percent over the last year; multifamily is up 12 percent.
- Despite skyrocketing rents, multifamily prices have risen so much faster that “cap” rates (net operating income divided by the property price) have sunk to a 16-year low.
Why deviate to a CRE chit-chat in the middle of a corporate bond discussion? In so many words, financing is financing. Whether it’s the capital markets the Fed has kept wide open or banks, companies need access to sources of leverage, especially in times of need and extra especially in times of illiquidity. Stressed smaller banks in particular will be inhibited in their ability to extend lifelines to smaller companies in the coming years.
Speaking of illiquidity but not of small banks, over the past seven years, assets on the biggest banks’ balance sheets have fallen from $5 trillion to $3 trillion. Zero in on corporate bond inventories and you find that dealer holdings have collapsed by 75 percent since the onset of the financial crisis.
Who’s taken up the slack? Whom, pray tell, do you, Joe Q Bond Fund Manager, ping when you need to offload a few billion in bonds? Let’s just say the nontraditional entrants who provide bond market liquidity during the next rout won’t be nearly as polite when it comes to maintaining market stability and pricing. They might even behave a bit like vultures. The more you need to sell, the lower the price.
For this neat noose secured round our necks, we have the regulators to thank. Will bond investors sing along to the greatest hit that has yet to be released by those Rocking Regulatory trio of Dodd, Frank & Basel? Tossing tomatoes onto the stage will more likely be the case.
In the event you’ve begun to sweat, you might want to reach for more than a Kleenex. In a normal world, the bulk of the risk inherent in owning bonds was credit-related. But years of distortive low-interest rate policy have flipped bonds’ risk/return dynamic on its head. Using Barclays US-dollar Aggregate Corporate Bond Index, ‘duration’ now accounts for 90 percent of the risk of holdings bonds, with the balance related to credit; that’s up from 37 percent in 2013. Think of duration as your bonds’ sensitivity to interest rate risk. Kind of gives a whole new meaning to no sudden moves.
Thank heavens for geographic diversification? Ah, you must refer to those essential emerging markets (EM) bond holdings, a must have for any discerning investor. No doubt, they’re the ‘it’ girl. Dollar-denominated EM debt sales were already up 160 percent through May over 2016 to $160 billion, marking the fastest annual start to the year since 1999.
Let’s just say the Bank of International Settlements (BIS) isn’t quite so enthusiastic. The BIS is often referred to as the central bank to central banks. In its estimation, there is a total of $3 trillion in dollar-denominated EM credit worldwide. The BIS’ chief economist Claudio Borio warned in the BIS’ recently released annual report that, “dollar funding remains a potential pressure point in the international monetary and financial system.”
The IMF concurred, warning that in a tightening environment, “the weak tail of emerging economy firms” would be highly vulnerable. The report added that, “A sustained reversal of capital inflows would put pressure on countries with high external financing and/or low reserve adequacy.”
At least China’s got that going for it, as in $3 trillion in foreign reserves. The problem is that only a trillion is considered to be truly liquid, while another trillion is earmarked to build that expanse of infrastructure connecting China to the western world once and for all. After all, you don’t become dominant by being isolationists. Oops, well you get the point.
The BIS estimates that Chinese corporate debt is 169 percent of its GDP. Would you believe that eye-watering and disconcerting figure is realistically on the light side? My good friend Leland Miller sagely suggests one apply the apropos grain of salt to what Chinese statisticians generously refer to as ‘GDP.’ So round down the denominator, way down. Add in the fact the corporations might not be fessing up to what their liabilities really are (who wants to be Debbie Downer?) and or never repay it so why report it? So round up the numerator, way up.
And, you guessed it, who in the world can say with any authority how buried in debt Chinese corporations are? So there’s that lovely black box to ponder.
The takeaway is that ‘bonds’ just ain’t what they used to be. Don’t be comforted by your broker telling you they help you diversify or that they carry bullet proof credit ratings. Sit him or her down instead and warn of the real risks of swollen durations, of bonds of all stripes slipping into rusty junkyards, of our portfolios’ safest holdings crossing over, and not in the good way those country hits do for us pop enthusiasts.
Do yourself a favor. Have a listen to Body like a Back Road. It’s easy enough to find in your car, on that mean machine at the gym, or wherever you prefer to slow down and have a listen. You’ll be grateful you did as summer drags on, closing your eyes and imagining the luxury of going 15 in a 30. It beats the heck out of what your bonds are apt to do when inclement weather hits, which will feel more like going 100 in a 50 on bald tires. And who wants to listen to that?