Watch the Leverage!
As chief investment officer of fixed income at Guggenheim Partners, Walsh is most concerned about high levels of corporate debt.
She referred to a chart depicting US 10-year Treasury yields over 218 years that showed how interest rates can remain low for extended periods of time.
“Rates stayed below 3% for 20 years before, during, and after WWII,” she said. “Interest rate levels we’ve experienced since the GFC [global financial crisis] are more the long-term norm.”
US 10-Year Treasury Yield
Source: Bloomberg, Robert Shiller, and Guggenheim Investments. Data as of 30 May 2018.
An anomaly occurred back in the 1970s and 1980s when rates spiked upward, Walsh observed. With the amount of leverage in the system and various disinflationary forces at work today, she believes that the yield on the 10-year Treasury bond will not break out of its band around 3% any time soon and will not reach the 6% level that some have forecast.
Expansion Continues, But Risk of Recession in 2020
The good news from a macro perspective is that US GDP growth is running above potential, business and consumer confidence are at cyclical highs, and labor markets have pushed through to full employment levels.
At the same time, the US Federal Reserve is continuing on its path to raise short-term interest rates and shrink its $4-trillion balance sheet. But the Fed has never been able to engineer soft landings in the past. “The risk is we end up over the cliff,” Walsh said.
History suggests recessions occur about three years after the economy achieves full employment. Another ominous sign is the current slowdown in money supply growth to below 5% — a level that has historically preceded recessions. Guggenheim’s overall economic research points to a recession in early 2020, Walsh said.
The Problem — Mounting Corporate Debt
Unlike the financial crisis, which at its core was driven by consumer debt, Walsh expects the next crisis to result from overborrowing in the corporate sector. So investors should “Watch the leverage!” she said. Corporate debt is nearing record levels and the ratio of nonfinancial corporate liabilities to GDP has reached 100% — well above 2007 levels.
Ratio of US Nonfinancial Corporate Liabilities to GDP and Average Investment-Grade Corporate Bond Yields
Source: Haver, Guggenheim Investments. Data as of 31 December 2017. Corporate bond yields are based on Bloomberg Barclays Investment-Grade Corporate Bond Index, and are smoothed based on a three-month average of monthly data before December 1989 and a three-month average of daily data from December 1989 to the present.
Moreover, US companies are expected to inject $2.5 trillion into the S&P 500 market cap, or 10%, through buybacks, dividends, and M&A activity in 2018, according to UBS. Walsh is especially concerned about companies that have issued debt to buy back stock.
In the high-yield markets, leveraged loan activity has risen from $500 billion in 2007 to over $1 trillion as of the second quarter of 2018. “Seventy percent of leveraged loans today are ‘covenant lite,’” Walsh said, and will not protect bondholders during the next default wave.
And risk isn’t limited to the high-yield bond sector. In 2007, Citigroup’s U.S. Broad Investment Grade Corporate Bond Index, valued at $1.7 trillion, had less than 40% BBB bonds. Since that time, debt has grown significantly. By the end of 2017, the index measured $5 trillion, with 47% in the BBB sector.
“According to Moody’s, BBB rated corporate bonds have an 18% chance of being downgraded to non-investment grade within five years. For single-A bonds this figure is 3%,” Walsh said.
She warned investors about sourcing yield through BBB bonds. She believes insurance companies, pension funds, and financial services firms that typically buy BBBs may be overwhelmed by a downgrade wave in the next recession.
Some Worrisome Differences This Time
Liquidity risk is always top of mind for Walsh as a credit investor. One problematic area is the liquidity mismatch in some fixed-income exchange-traded funds (ETFs). “Bank loan ETFs advertise immediate liquidity, but the underlying securities often take three weeks to settle,” she said. The SEC and Federal Reserve have proposed “gates” to slow down withdrawals, but Walsh wonders about negative spill-over effects into other, more liquid markets.
Also, market structure has changed: Investment banks no longer hold inventory in corporate bonds because of increased costs of capital. So, there is no longer a liquidity provider that can step in during a crisis.
Finally, Walsh believes some of the newer rating agencies have lax standards and are overrating some bonds — particularly in private placements.
Where to Invest Now
“My portfolio has not been this high quality since 2007,” Walsh said. She likes more seasoned AAA collateralized loan obligations (CLOs) that have experienced a 0% average five-year loss rate since 1993. “The AAAs were the only ones that passed our CLO stress test,” she said. Walsh also makes sure the CLO issuer has experience and financial staying power.
In addition, she likes bonds that pay back principal — for example, secured asset-backed securities [ABS] in the aircraft financing sector — but believes even hard assets may be difficult to sell in the next recession.
Walsh expects another spread widening event in the future: “Either it will be fundamentally driven (recession) or a ‘risk off’ scenario — perhaps from a realization that there is just too much debt outstanding,” she said.
On the other hand, with $7 trillion of global debt still with negative yields, international buyers continue to come in to hold US markets together. The largest buyers of CLOs are Japanese banks, and the Europeans like the bank loan segments, Walsh observed.
In the short run, she expects mild inflation — but longer term, she believes disinflationary forces will win out. Changing consumer spending patterns due to demographic trends and the reduction of input costs from emerging technologies like blockchain will keep inflation low. Even trade wars could have a neutral effect on inflation longer term, as buyers find substitutes.
Given investment flows into fixed income from international buyers, expectations for continued low inflation, and Walsh’s view that rates can only rise so much in a highly leveraged economy, “The bull market in bonds is not necessarily over,” she said.
But Walsh does expect continued volatility in fixed-income markets and is mindful of some significant risks along the way.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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