Darwin and Debt

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Darwin and Debt

Today (Sunday) marks the 160th anniversary of the publication of Charles Darwin’s “On the Origin of Species”; I am celebrating the event by visiting the Creation Museum in Petersburg, Kentucky this afternoon. Long time readers may recall that every year I drive from New York to Memphis to visit the in-laws for Thanksgiving. I am on the outbound leg of that trip this weekend, which takes me within 20 minutes of Petersburg. And the combination of a round-number birthday for the seminal tract on evolution with the chance to see a robust defense of creationism is simply too good to pass up.

The complete title of Darwin’s work – “On the Origin of Species by Means of Natural Selection, or the Preservation of Favored Races in the Struggle for Life” – got me to thinking about US corporate debt levels (yes, it’s a long drive…). Structurally low interest rates over the last decade, combined with low-but-steady economic growth, is the “environment” in which US companies operate. They have adapted to that by taking on more debt.

More, in fact, than at any point in history, as this chart of “Nonfinancial Corporate Business Debt to GDP” from a May 2019 Fed blog post shows:

But the fact that every peak since the 1980s coincides with the start of a US recession shows, of course, that economic environments can – and do – change. Debt markets are essentially their own ever-adaptive “animal”. When economic slowdowns occur they become more selective, both demanding better terms from borrowers and shunning less credit-worthy issuers.

While both debt and equity markets seem to have come off “recession watch” in recent weeks, it still pays to look at corporate credit spreads across the quality spectrum. We occasionally do this selectively in these notes, but today we will run through the whole range and look all the way back to the 1990s to add some historical perspective.

First, here is the interest rate differential between US investment grade corporate bond rates and that of Treasuries (all charts below courtesy of the St. Louis Fed FRED database):

Worth noting:

  • The current difference of 114 basis points is among the tightest spreads in the last decade. The only more favorable period for investment grade bonds was Q4 2017/Q1 2018.
  • Line up this chart with the previous one and you’ll see that current spreads are close to the 2004 – 2007 period (when spreads were 90 – 100 bp) even though corporate debt levels are much higher than the last cycle (+45% of GDP versus 40%).
  • Bottom line: low interest rates and peak-ish corporate operating margins are making for very tight investment grade corporate bond spreads, and current market pricing says there is little risk either will change in the near future.

Next, let’s look at US high yield corporate spreads:

Worth noting:

  • The current spread of 417 basis points is noticeably higher than recent (2017 – early/mid 2018) experience, when the difference between junk and Treasury yields ran 320 – 400 basis points.
  • Current spreads are also higher than the middle/end of the last cycle (2006 – mid 2007), when they ran 250 – 340 bp.
  • Bottom line: unlike with the investment grade bond data, here we do see the market pricing in some concerns about debt levels and/or the state of the US economy.

Now, let’s look at the two most marginal corporate debt ratings, starting with single B credits:

Worth noting:

  • At 428 basis points, current single-B spreads are 9 basis points higher than aggregate junk-bond spreads. This is slightly wider than the long-run average of 6 basis points.
  • While certainly higher than either the last cycle (early 2007’s 260 bp) or even just last year (June – October’s 360/370 levels), this year’s single B spreads are stable.
  • Bottom line: this looks very much like the prior data, indicating some (but not a lot) of macro concern.

Finally, we’ll take a look at the spreads over Treasuries for corporate bonds rated CCC or below:

Worth noting:

  • At 1,144 basis points, CCC/below spreads are clearly widening just now (unlike all the other charts above).
  • These bonds are not just “fallen angels” – companies do issue CCC debt.
  • Bottom line: here, at the bottom of the credit spectrum, we find clear signs of market unease with high corporate leverage levels.

Summing up with two observations:

#1: All this is one more reason for the Federal Reserve to worry about deflation in the next recession. Record levels of corporate debt are only OK if operating margins – a function of units sold and prices paid – remain strong. Recessions always see lower unit demand, but negative pricing power would be an unwelcomed development and reduce structural cash flows.

#2: At present, the US corporate bond market is not especially worried about a 2020 recession. Yes, high yield spreads are a bit wider than last year, a trend we also see in lower-grade B and CCC credits. But aside from that last classification, spreads look to be within normal bands.

Sources:

NY Fed Blog Post on Corporate Debt: https://libertystreeteconomics.newyorkfed.org/2019/05/is-there-too-much-business-debt.html