Rationalizing Peak-Cycle Numbers: Investors "Unconcerned" About Record Corporate Debt
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.