Concerning Observations from the Bond Market

"If something cannot go on forever, it will stop" - Herbert Stein

Ten years ago this August, the French bank BNP Paribas froze three funds exposed to US subprime mortgages, an event many consider to be the beginning of the financial crisis. In "celebration" of the 10 year anniversary, I wanted to share some concerning observations from global fixed income markets:

• Since the beginning of the year, the yield curve has flattened
•  The 2s10s treasury spread went from 125 bps to 87 bps today
• The Fed dot plot implies 1 more 25 bp rate hike in 2017, and 3 more 25 bp rate hikes in 2018 
• That makes 100 bps over the next 16 months, the long end better go up....
• Flattening yield curves usually precede recessions
• Global Debt is a 325% of GDP
• Corporate Debt levels are 30% higher today than in 2008
• Corporate Debt to GDP is at its highest point in history
• NACM (National Association of Credit Management) have cited deteriorating credit conditions since 2014
• The IMF recently noted US corporates have raised leverage to levels they see as a future source of financial instability
• In the IMF's Global Financial Stability Report, firms accounting for almost $4 trillion worth of assets could find it difficult to service their debts if interest rates were to rise sharply from here
• Per ASR, 43% of US companies had interest coverage ratios below 2 in 2015, these same companies accounted for 29% of the total stock of debt
• In 2016 25% of US firms had interest coverage ratios below 1
• In the US, 10 companies account for 31% of total stock of cash, and 50 companies account for over half of it
• One third of US companies are in the "distress zone" per Altman Z score
• US Net Debt/Sales is the at the highest level in 25 years, so is Net Debt/Equity
• Tesla plans to raise $1.5 billion in debt - Tesla FCFF hit a record -$1.2 billion in Q2 2017 and is on track to hit -$2.0 billion by year end
• Per ASR, until recently the most highly levered companies had been accounting for an increasing percentage of share buybacks
• In the US investment grade index: the banking sector is highly regulated, high barriers to entry, implicit government backing, and have engaged in the least amount of shareholder distributions since the financial crisis
• Yet investment grade bank issuers trade wider than the index
• Since the financial crisis, corporate bond indices have increased their duration from below 7 to greater than 9 years
• The possibility of tax reform is looking less likely by the day, but perhaps the Republicans can still pass legislation including repatriation of off shore cash
• However almost half of the off shore cash  ($1.5 trillion), is not piles of money stored in Cayman Island vaults; it is invested in short term corporate bonds - that's a big sell order!
• Over the past 10 years, firms in the S&P 500 have returned more money to shareholders than they have earned
• During 2017 the high yield skew (how much investors are willing to pay for puts versus calls) has been steadily increasing
• Both US investment grade and high yield indices have spreads near 10 year tights 
• Per the Fed - at the end of June, total revolving credit rose to a new all time high
• Total non-revolving credit also hit a new all time high
• US student and auto loans hit record highs
• US household savings rate declined in tandem
• Per Moody's, the proportion of the loan market that is "convenant-lite"has risen from 27% in 2015 to more than 66% by Q1 2017
• Some of these "convenant-lite" loans even have restrictions on the lender!
• Sometimes private equity firms demand veto power over secondary market buyers of loans they owe - to avoid debt being bought by activist investors who might make demands on a company's management
• The Commercial Property Price Index experienced its first YoY decline since the financial crisis
• The Fed listed commercial real estate on its "worry" board
• The Republicans control all three levers of the federal government; why has the debt ceiling not been taken care of?
• The yield on the 10 year US treasury is greater than the yield on European junk bonds 
• The yield of the 10 year US treasury is greater than the yield on Italian debt
• The ECB is running out of bonds to buy for its PSPP program
• The BoJ is running out of JGBs to buy
• In Europe, 10 companies account for 26% of the total stock of cash, and the top 50 companies account for 46% of cash
• The Bank of International Settlements labels a firm a zombie company when it's: a listed firm, with 10 years of existence, and a ratio of EBIT relative to interest expense <1. They merely survive by constantly refinancing debt, restructuring due to low interest rates, and are unable to cover interest expenses with profits - let alone repay principal
• Per the Bank of International Settlements, from the financial crisis the percentage of firms in Europe that are zombie companies has increased from 7.5% to 10.5%
• Per a recent Bank of England study, if a 1% outflow of European credit mutual funds happened today, European IG spreads would rise 40 bps on liquidity alone
• 40 bps on European IG spreads equated to a third of the average spread since 2000
• The Bank of International Settlements tagged unsustainable credit growth relative to GDP in both households and non-financial corporates for three countries: China, Canada, Australia
• Both Canada and Australia have overheating housing markets and high exposures to natural resource markets
• China has accounted for 70% of global corporate debt since the financial crisis
• The China Banking Regulatory Commission reports that the Chinese banking system had $35 trillion in balance sheet assets to GDP through Q1 2017
• This would equate to a 4x bank credit expansion since 2008
• This would also equate to a bank assets to GDP ratio that is 3x larger than the US ratio before the financial crisis
• A British newspaper, the Daily Telegraph, cited a leaked People's Bank of China 2017 Annual Stability Report completed in June, that stated off-balance sheet assets are between $30-$40 trillion
• If you added up both on and off balance sheet assets in China, it would equate to 650% of GDP
• Last month, a the Chinese textile company Shandong Ruyi Science and Technology Group Co. sold a 5y bond with no documentation of ownership structure (Chinese corporates often have implicit state backing), the bond is still trading near issuance pricing
• This is commonplace in Chinese corporate markets
• Argentina just issued a 100 year bond at a 7.9% yield
• Argentina has defaulted 6x during the previous century
• In case you wanted the privilege of owning emerging market paper at 6.75%  yield from a war torn middle eastern "country", infested with ISIS & Shia militias, a disenfranchised populace, Kurdish separatist movement, a government regime tied closely with US adversary Iran, and an economy reliant on oil - the Iraqi bond deal last week was 7x oversubscribed so you may not have been so lucky
• ......Greece also completed a bond deal last month; Greece is a ponzi scheme
• Donald Trump gets to pick the next Fed chair

I know, a lot of these observations are statistics without context. Many of these statistics were more or less true 2 or 3 years ago, and the bull market persisted. Structural demand, and a thirst for yield may prevent interest rates from rising to levels that could threaten credit markets for many years. Global central banks are aware of these risks in credit markets and cognizant of historical mistakes made by monetary policymakers. Still, it is important to understand that at current levels global credit markets are expensive, and prospective future returns are low. Considering the mechanics of fixed income investing, with yields already extremely low, the risk profile is skewed to the downside. Valuations and market sentiment have diverged from fundamentals, even if the drivers of that divergence may persist. Investors would be wise to underweight credit risk; they are simply not being compensated for it.