The Bear’s Lair: Corporate debts are today’s worst assets

The silly-money policies of the last decade have left almost all assets overvalued. Real estate, public and private equity, especially in the tech sector, collectibles, debt in general and emerging markets are all well above sustainable levels. But if we are looking for a catalyst for the next market disaster, there is one outstanding candidate – corporate debt of large companies. It had a relatively gentle let-down last time around, and its market is exceptionally opaque even by the standards of today’s murky financial markets.

In looking at disasters to come, it is perhaps easiest to catalogue the few areas that appear unlikely to suffer a major crash. U.S. housing and mortgage loans came a cropper in 2007-08 and, outside a very few world metropolises, only started recovering around 2013; house prices and mortgage lending standards have not recovered anywhere near enough to a major source of trouble this time around. That is not to say top-end real estate in New York and San Francisco won’t crash; indeed, it is already crashing. In London also, there has been no significant real estate price downturn since 1988-94; that market is far overdue for a major meltdown, Brexit or no Brexit. However, these localized problems, while painful to residents in those cities and to the more overextended lenders, are unlikely to cause a systemic crash.

Another area that will not cause a financial crash this time is bank loans to small companies. While corporate loans have increased somewhat since 2007, from 14.5% of bank credit to 17.5%, the great majority of such loans today are to large companies, often through leveraged buyouts arranged by private equity houses. As I discussed two weeks ago, small business lending has migrated away from the banks, because it is expensive in terms of bank analyst staff and not especially profitable. With small business lending taking place on various non-bank platforms, if it runs into difficulty, the banking sector will not be badly affected.

Non-financial corporate debt in the United States is on a continuing upward trend, fueled by low interest rates, from $3.1 trillion (40% of GDP) in 1995 to $6.3 trillion (44% of GDP) in 2007 to $9.7 trillion (47% of GDP) in 2018, based on Federal Reserve figures. That does not look alarming when you compare it to the equity of public non-financial companies which, fueled by the bull market, has risen to $26 trillion in 2018. However, companies have been repurchasing shares like madmen, so the tangible book value of public companies is a small fraction of that figure, certainly less than their outstanding debt.

Corporate debt would be no more alarming than half a dozen asset classes whose value has been inflated, but for two things: the lack of transparency in its market and the conflicted incentives of its investor base.

This has resulted in games being played, such as in the current problems at H2O Asset Management, a London-based bond fund company linked to the French bank Natixis with some $40 billion in assets under management. H2O sells shares in its bond funds to retail investors, primarily in continental Europe; its problems have been helpfully highlighted by the FT’s Alphaville section.

Continental European investors have a strange liking for high-yield bond investment, taking huge risks on their portfolios in return for modest increases in promised return. The fixed coupon on bonds appeals to them more than the uncertain returns on equities, even if the bonds are so junky that the returns are unlikely to be realized. Hence the enthusiasm of dozy Italian investors a couple of years ago for 100-year bonds of the Republic of Argentina, a maturity that is about 15 Argentine default cycles away. Thus, bond funds like H20 focusing on the continental retail investor market and investing in lower-quality debt are common.

H20 has a substantial portion of its portfolio in “Level 3” assets, an accounting category that this column remembers well from the trouble it caused last time around. If an asset falls in the “Level 3” category, there is deemed to be no adequately available market price, and so the fund manager values the asset itself on a daily basis – a process that is asking for trouble if that valuation is then used to calculate the pricing of a publicly traded fund.

In H20’s case the problem appears to have arisen from $1.5 billion of bonds of a German entrepreneur Lars Windhorst, including 300 million euros of a 500 million euros bond issue of Perla, an Italian lingerie company controlled by Windhorst that made annual operating losses of around $100 million. As the H20 filing stated “Lars Windhorst has over the past four years referred valuable investment opportunities to us” – of course, it didn’t say to whom the investment opportunities were valuable!

This is presumably all legal if borderline, but it gives rise to huge conflicts of interest. Windhorst can get bond issue money, indeed the majority of some of individual issues, from H20 because of his relationship with the fund manager. If H20 is taking more than half an individual issue of bonds, the issuer does not need to satisfy market criteria as to its soundness and return. There is no market price check on the bonds once issued, because H20 values them on a “Level 3” basis – since it owns more than half the issue, there is essentially no liquidity anyway.

Therefore, investors in the H20 funds have no idea that the bonds the fund invests in are anything other than top quality so long as the interest on them is paid – there is no market price and the value in the fund stays close to par unless there is trouble. This is quite different from an equity investment where there is a stock exchange listing, independent of the H20 funds, that gives at least a nominal price and tells investors how many shares are being traded each day. The opportunities for chicanery and fraud are immense, whether or not any individual transaction is fraudulent.

There are two other factors leading one to believe that corporate debt is an especially vulnerable asset class in this cycle. First, the volume of stock repurchases of public companies has been unprecedented, so that major corporations such as Boeing (NYSE:BA) are carrying on vast businesses without any equity capital. Aircraft manufacturing is a highly cyclical business; there is no reason to believe that Boeing can operate through a downturn on the basis of infinite leverage, without a cushion of stockholders’ equity. While some other companies with this characteristic, such as McDonalds (NYSE:MCD) may be effectively recession-proof, there is no reason to believe they all are, and there are now a lot of them.

These companies without equity are essentially in the position of subprime mortgage pools in the last cycle; they are operating beyond the normal rules of corporate finance, in the belief that “this time it’s different.” Well, the Gods of the Copybook Headings tend to visit about once a decade, and this kind of arrogant disdain for past rules is exactly the thing they are quickest to punish.

The other factor leading me to believe that corporate debt is especially vulnerable is the vast increase in the volume of private equity funds carrying out leveraged buyouts. This has meant that a very large number of exceptionally aggressive, greedy and persuasive financiers have been competing to force debt down the throats of any investor who will buy. Again, past experience shows that all that testosterone concentrated in one area is bound to produce especially unhappy outcomes for investors. Normal guidelines for debt covenants on such transactions were blown through as early as 2011 or so; we have been in uncharted waters in this market for several years.

When excessive liquidity courses through the global economy, investors will believe anything. Just one example from today’s news, relating to a typical creature of funny money and this decade’s bubble: The media are taking at face value Elon Musk’s claim that his intercontinental rocket flights will last “15-20 minutes.” In real, non-bubble life, that is physically impossible – the lowest possible time for a rocket to orbit the earth is 84 minutes – so 42 minutes from London to Australia, or New York to Singapore. Any faster, and the thing flies off into space from centrifugal force and is lost forever. In this case, the laws of physics provide us with a corrective to Musk’s claims.

Just as physics provides a useful corrective to the claims of promoters, so in a money-fueled bubble, investors need instruments with independent pricing, so they don’t get carried away by their intoxication. Of all asset classes, junk corporate debt offers investors the least such independent price information – it is in this respect much less transparent and sound than crypto-currencies, for example. Since it missed out on crashing in 2000 and 2007-08, the corporate debt asset class is thus due for an especially nasty implosion this time around.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)