Credit Where Credit is Due – A Brexit Distraction
And that is the last time I shall mention the ‘B’ word in this piece.
Regular readers and investors will be familiar with our thematic approach to investing rather than the conventional geography and asset class template commonly used in our industry.
We publish our key investment themes to invest in but don’t often mention what we actively seek to avoid as themes. We do mention them in blogs and mid-monthly updates occasionally as we did in November’s update. For example, it is important to avoid leverage and interest rate sensitivity as the interest rate cycle turns upwards and monetary policy tightens. As interest rates rise, the cost of servicing debt increases and those businesses with too much debt suffer.
In last month’s mid-monthly update, we commented on the demise of Sears, a long-standing US retailer – akin to M&S going bust in the UK.
If you live on credit, at some stage the debts you have built up become due.
In the 1980s, a signature of corporate health, vigour and dependability was a AAA credit rating, the highest there was. One of those companies that valued its AAA status was General Electric or GE as it is generally known. The company was led at that time by Jack Welch who was CEO from 1981 until 2001. Jack was viewed as something of a visionary in the corporate world for much of his tenure at GE. He earned the dubious nickname of ‘Neutron Jack’ for his ability to cut staff numbers in the 1980s. He is reported to be furious with the subsequent management of GE and its current travails. GE’s stock price was $32.88 in July 2016, the highest price in the last five years, at the time of writing (4/12/18) it traded below $8. The company may be lucky to survive. This is a company with a market capitalisation of $63 billion and outstanding long-term debt of $115 billion. It employs 313,000 people worldwide.
A Bit of History
Like GE in the 1980s, many famous brand names like Kelloggs and Campbell Soups enjoyed the financial machismo of a strong credit rating, usually AAA, the best. In the mid-1980s as interest rates subsided in the post-Paul Volcker (US Federal Reserve Chairman from 1979 to 1987) monetary response to the high inflation at the end of the 1970s, a highly successful high yield bond trader named Mike Milken significantly altered the corporate bond landscape. Given his successes at trading high yield debt at Drexel Burnham, Milken had significant institutional investors’ backing. This enabled Milken to embark on enabling an M&A boom. These were known as Leveraged Buy-Outs (LBOs) where Milken could place the high yield debt of downgraded corporates bought out by debt and serviced by regular cashflows from those businesses. Of course, problems arose if those companies, now with highly leveraged balance sheets, suffered a business downturn and struggled to service their debt. One of the by-products of Milken’s successful bond business at Drexel Burnham, was that it persuaded a number of higher rated credits to leverage their balance sheets but retain an investment grade credit rating, albeit the lowest – BBB, and avoid the clutches of the mergers and acquisition hungry firms like KKR (Kohlberg, Kravis & Roberts).
Milken was so successful that he moved his high yield bond operation from New York to Los Angeles – because he could. Things didn’t go so well for Mike Milken as he later served a custodial sentence for violating US Securities laws for which he pleaded guilty. However, today aged 72, he runs a successful educational business in the US with his brother and is known for his philanthropy.
Back to Today
Many companies have survived due to extremely low interest rates over the past ten years from quantitative easing (QE) others have used QE to increase borrowing to buy back stock and in the process increase leverage. Between 2010 and 2017, GE chose to spend $42 billion to buy back its own stock rather than pay down debt, consequently significantly leveraging its balance sheet. While GE still has a BBB+ stable credit rating, therefore maintaining its investment grade status, its bonds actually trade more like junk bonds (High Yield debt rated BB and below) as the graph below illustrates.
Much rests on the new CEO, John Flannery who has promised to adhere to a strong financial discipline and is in the process of disposing of non-core assets.
Meanwhile GE shares languish at multi-year lows.
The Great Financial Crisis (GFC) of 2008/9 was largely resolved by QE and the huge transfer of private debt into public debt, UK taxpayers are still the majority shareholders in RBS. In the intervening years, QE has enabled many companies to gorge themselves on assuming more debt. Consequently, corporate debt levels have climbed again, especially in BBB/BAA credits, the most leveraged of investment grade companies.
As the following graph depicts, when the corporate debt to GDP ratio exceeds 44%, default rates spike higher.
The weight of BBB debt and the potential for a spike in default rates is possibly the reason why investment grade spreads are rising. See below.
Most charts included in this piece are taken from The Wall Street Journal’s Daily Shot even if they have sourced them from the quoted source.
As we stated at the outset, it is important to avoid some themes and good investing is often about what you don’t invest in. We have never been fans of leverage but at this stage of the economic and monetary cycles, steering clear of leveraged businesses is even more important.