Here's How to Navigate the Great Debt Binge of 2020

There should be no doubt that U.S. companies are on a debt binge in 2020. Already, public market debt sales have surpassed $1.4 trillion. Investment-grade debt sales are already greater than all of 2019, and junk bond deals are running almost 40% ahead of last year's pace. We will likely break the all-time debt issuance record set in 2017 before Labor Day. I'm someone who buys corporate bonds for a living, and I've been generally pretty sanguine about the risks of corporate leveraging in recent years. Right now, however, the combination of high uncertainty, weak earnings, and a misunderstood Federal Reserve, is creating a unique set of risks for markets. Unfortunately, the real risks aren't the ones you are reading in the investment press. Here's what you should really be watching and how it should impact your investment decisions. Leverage Doesn't Kill Companies... Leverage itself doesn't cause defaults. What it does is narrow the path. Say a company makes $100 in revenue and has $75 in costs excluding interest. How much debt can this company afford? It actually depends entirely on how variable the revenue is and how much the company can control the costs. If the $100 in sales and $75 in costs were completely fixed now and forever, the company could take on debt such that interest costs were $24 without risk. If the sales figure bounces all around, then taking on any debt at all might be too risky. This extremely simple example shows us two things. One is what really matters is debt payments vs. free cash flow. The amount of debt a company (or the whole economy) has outstanding isn't particularly important. Second, it matters quite a bit what kinds of companies are taking on the debt and how much they can predict (or control) their incoming cash flow. Don't Fight the Last War The housing bubble earlier in the 2000s was driven by leverage, some of which was funded in the shadow banking world. There are some parallels today, but they are superficial. Unfortunately these tenuous parallels are leading to an avalanche of bad takes. Let me dispense with the two I hear most often. First, the surge in company debt is just like the surge in housing debt, and will end similarly. That doesn't stand up to even a small amount of scrutiny. Housing leverage became so problematic because it underpinned the whole banking system. In addition, once banks started seizing homes, it created downward pressure on home prices. This created a bad feedback loop, where lower house prices caused more defaults, which caused lower housing prices. You could have some concentration of defaults in company debt (shale oil or retailers) but there's no way it has such a wide contagion effect as home prices did. The shadow banking argument is actually even weaker. In the 2000s there was a surge in collateralized debt obligations (CDOs) that were filled with housing debt. The only thing those CDOs have in common with today's collateralized loan obligations (CLOs) is that they both have a C and an O in their acronym. The core reason why CDOs caused so much trouble in 2008 was that they were relying on the same asset (houses) that the rest of the banking system was. It was the concentration all in one asset that caused all the trouble. CDOs were just the packaging. Today's CLOs are full of various types of company debt. There isn't this single-asset problem to cause such contagion. That isn't to say I love CLOs as an investment. I actually have the lightest allocation to CLOs today than anytime in the last five years. But they aren't a bomb about to explode on the rest of the economy. What's the Risk of the Leverage? Ironically, when I hear commentators talk about risks related to leverage, it is almost always one of the points above. It is as though leverage needs to cause a crisis or it isn't worth talking about. But what if the increase in debt merely causes value to accrue to debt holders instead of stock holders? What if owning levered companies just causes your stock returns to stink? That might not make for a sexy headline, but it sure should matter for investors. Let's take a look at what's actually happened so far this year. I took all the public companies in the bond fund, the iShares iBoxx High Yield Corporate Bond exchange traded fund . I used that as a proxy for stock performance of more levered companies. I weighted it the same way HYG is weighted, which is by debt outstanding. Year-to-date through Tuesday, this set of stocks is down 20.9%. The S&P 500 is only down 2.1%. The poor stock performance isn't driven by companies under stress. Even if we only look at companies where the bond is priced above $90, for example, companies that aren't particularly stressed, the year-to-date performance is negative 17.4%. What's going on here? Certainly the types of companies in the high-yield index aren't the same as what's in the S&P 500. Junk bonds are over-represented by cyclical industries like metals or energy. But the poor performance from more leveraged companies persists, even when we correct for this. Take the companies in the SPDR Technology ETF . Within this basket, companies that have less than zero net debt are up 14.3% on average so far this year. Companies with net debt to EBITDA between zero and one times are up 6.2%. Companies with debt to EBITDA over one times are down 7.3%. Value Accrues to Holders of Debt First, Stocks Second Right now, earnings are highly uncertain for many companies. What isn't in question is that you have to make your debt payments. Some companies will go bust, but that's only going to be a few. Many more companies are going to see their earnings decline, not just because of the lockdowns, but because of lasting economic damage. Most of those companies will get back on their feet, but they'll still have debt payments to make. That means a lot of the earnings recovery winds up flowing to bond holders, not to the stock recovering. So the increase in company leverage is probably not going to cause some kind of banking crisis. But it is going to weigh on stock prices for those companies that took on (or are taking on now) too much leverage.

Here's How to Navigate the Great Debt Binge of 2020

The risks are likely different from what you've been told. Here's what you should be watching instead and how it could impact your investment decisions.

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