‘Pigs Just Might Fly’ In A World Where Spreads Are This Out Of Touch With Leverage

The disconnect between rising corporate leverage and post-crisis tights in spreads is something we’ve spent a lot of time talking about. And for good reason.

See the thing is, it doesn’t make any sense. It shouldn’t be the case that corporate management teams can leverage themselves to the hilt without paying (figuratively and literally in this case) a price for it.

But that’s the world we live in. This is a world where central banks have created a global hunt for yield and then supercharged it by working on both the supply and the demand side of the equation. Buying up corporate bonds with freshly-printed money weighs on supply and the very act of funneling trillions into the market creates demand by driving yields into the floor.

This creates perverse incentives for management. Corporates are incentivized to financial engineer their way to the promised land, issuing debt at artificially suppressed rates and plowing the proceeds into EPS-inflating buybacks.

SocGen

There’s a reason why the lion’s share of U.S. equity demand has come from the corporate bid over the past several years.

Buybacks

This dynamic is exacerbated by the prevalence of equity-linked compensation (see this from DealBreaker’s Owen Davis). Here’s how we described this in a piece out last month:

The main worry here is that corporates have leveraged themselves to the hilt in an environment characterized by an insatiable hunt for yield among investors. In order to keep the ravenous hordes sated, corporate management teams have simply met demand with more supply and in many cases used the proceeds to buy back shares in a “virtuous” loop that not only inflates the bottom line, but also boosts management’s equity-linked compensation. See? Everyone’s a winner! 

Of course that’s sarcasm. Everyone is not, in fact, a winner. Or at least not in the long-term.

So invariably, the dynamic described above ends up creating a situation where the market can no longer price debt in a way that’s commensurate with corporates’ ability to service that debt. This is the subject of a truly amusing piece out from Moody’s called “Less Fear, More Debt.”

“Times have changed,” the ratings agency begins, before adding that “in a world where core inflation ebbs amid a sharply lower jobless rate and corporate bond yield spreads narrow despite steeper leverage, pigs just might fly.”

Pigs

Yes, they “just might.” Consider this:

High-yield EDF metric shrugs off higher leverage ratio

Despite a climb by nonfinancial-corporate debt from Q2-2016’s 493% to Q2-2017’s 507% of internal funds (where both debt and internal funds are expressed in terms of moving yearlong averages), the average expected default frequency (EDF) metric of US/Canadian high-yield issuers fell from Q3-2016’s 4.7% to Q3-2017’s prospective 4.1%. (Figure 1.)

Moodys1

However, the statistical record shows that the high-yield EDF metric usually moves in the same direction as the ratio of corporate debt to internal funds. The coincident correlation between the EDF and this leverage ratio is a strong 0.81. As derived from their statistical relationship that begins with Q1-1996, a 507% yearlong ratio of debt to internal funds has been associated with a 6.8% midpoint for the high- yield EDF metric, which is far above September 27’s 3.8%.

And as noted in our own commentary above, the situation is even more egregious when you look at the juxtaposition between leverage and spreads:

The recent composite high-yield bond spread of 367 bp is even more confident of a benign outlook for defaults than is the average high-yield EDF metric. Nevertheless, the last three times corporate debt approximated 507% of internal funds in Q2-2008, Q2-2000, and Q4-1989, the high-yield bond spread averaged 646 bp. More specifically, the high-yield spread’s quarter-long averages were 675 bp in Q2- 2008, 631 bp in Q2-2000, and 632 bp in Q4-1989. (Figure 2.)

Moodys2

Moreover, the US high-yield default rate is expected to drop from Q4-2016’s 5.6% to 3.2% for Q4-2017 and, then, to further subside to 2.8% by Q2-2018. However, a rising ratio of debt to internal funds typically leads the default rate higher. The quarter-long average of the US high-yield default rate shows very significant correlations of 0.80 to 0.83 with the ratio of debt to internal funds from one to three quarters earlier.

The implications here are obvious, but in case they aren’t, allow us to leave you with Moody’s recap of what happened the last time the debt to internal funds ratio climbed to 507% while the the high-yield EDF metric was less- than-6%:

In 2008’s second quarter, corporate debt rose to 506% of internal funds, but the high-yield EDF metric was a comparatively low 3.86%.

However, by 2008’s final quarter, corporate debt reached 523% of internal funds and the high-yield EDF soared to 10.33%. At the same time, a mild recession was turning into a global calamity.

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