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Corporate America will bring next wave of pain, money managers warn

Bloomberg logoBloomberg 4/6/2018 John Gittelsohn

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Corporate America will beget the next wave of financial pain, or even recession, a growing choir of the world’s biggest money managers is warning.

After years of borrowing for stock buybacks and company buyouts at extremely low rates, the tide is turning as the Federal Reserve raises its target rate and pulls stimulus. That’ll pressure the swollen ranks of overleveraged firms and weigh on growth, Guggenheim Partners Global Chief Investment Officer Scott Minerd said. Pacific Investment Management Co. and BlackRock Inc. are among investors curbing purchases or being pickier about what they buy.

Debt levels crept up as central banks suppressed borrowing benchmarks, with the proportion of global highly leveraged companies -- those with a debt-to-earnings ratio at five times or greater -- hitting 37 percent in 2017 compared with 32 percent in 2007, according to S&P Global Ratings. When that burden collides with rising rates, it could cause a recession in the “late 2019 to mid 2020” window, Minerd wrote in an email.

“As funding rates rise, the burden from higher borrowing costs will end up stressing corporate America, which means companies will look for other ways to reduce expenses,” Minerd said. “Layoffs will feed into the labor market, reduced capital expenditures will directly impact GDP growth, and all of this will drive the probability of recession higher.”

Weak Fundamentals

Anticipating the pain, firms have scaled back on corporate credit. Brandywine Global Investment Management, with $74 billion in assets, reduced its exposure to less than 5 percent from as high as 50, according to Anujeet Sareen, portfolio manager with the Philadelphia-based unit of Legg Mason Inc.

TCW Group Inc. did likewise, curbing its exposure since 2016. It now limits recommended holdings to short-term debt in highly rated, low-leverage financial firms, such as U.S. banks, according to Jerry Cudzil, a portfolio manager at the fund company with about $200 billion.

“You grow cautious when you’re staring at illiquidity and weak fundamentals and changing technicals,” Cudzil said.

U.S. investment grade bonds posted their worst first quarter since 1996, while speculative grade bonds posted their biggest loss for the same period since the financial crisis, according to index data. It’s a performance that left some feeling vindicated.

a screenshot of a cell phone: Sinking Returns© Bloomberg Sinking Returns

“The big loser this year, as we predicted it would be, are corporate bonds,” Jeffrey Gundlach, whose DoubleLine Capital oversees $119 billion, said in a March 13 webcast. “Trouble is here, people.”

Pimco guides investors to be very selective about buying corporate debt and avoids “generic” investment-grade and high-yield securities, according to a March report by Joachim Fels and Andrew Balls. The housing sector, including a range of mortgage-backed securities, is the strongest area of credit while other bonds should be purchased selectively, with an emphasis on short-term debt, they said.

In particular, investors in the U.S. junk-bond market are becoming more choosy and less tolerant of debt backing risky takeovers, according to Rick Rieder, global chief investment officer for fixed-income at BlackRock Inc.

Few Defaults

To be sure, some say it’s premature to abandon credit. Improved cash flows aided by U.S. corporate tax cuts and a long runway to refinance debt have pushed the day of reckoning farther into the future. The number of corporate defaults globally fell to a three-year low of 95 in 2017, according to a report Thursday by S&P.

“We’re not yet short credit,” Ken Leech, chief investment officer of Western Asset Management Co., said at a March 27 investor conference.

But change can happen with surprising speed -- and it can be accelerated if the economic climate sours. Some debt sold by Toys “R” Us Inc. traded around 96 cents on the dollar in August 2017, Minerd said, before plummeting to 26 cents a month later when it filed for bankruptcy. Tesla Inc. sold $1.8 billion of debt last August that traded around the par level. Today, its asking price is about 89 cents.

“Collectively, we’ll see more issues like this as we near the tide turning,” Minerd said.


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