2018_10_13 — “U.S. Corporate Bonds: Watch for Danger Signs”
October 13, 2018
U.S. Corporate Bonds: Watch for Danger Signs
U.S. Corporate Bonds: Watch for Danger Signs
The major risk facing corporate bonds is technology (and its affects on balance sheets), not the economy.
- The tide has turned for corporate credit quality
- Rating downgrades could send a surge of BBB investment grades into the junk category and swamp high yield with enormous supply
- The threat and expense of technology is a thorn in the side of corporate balance sheets
My models suggest that the corporate default rate will move somewhat higher over the next couple years, even in the absence of recession: continued equity buybacks, dividend payments, capital expenditures (capex) on technology, social media marketing, and internet security, as well as other unchecked expenses in a good times economy will deteriorate corporate health. The deterioration has thus far been mild for the corporate sector, and it is moving from a healthy starting point; therefore, absent a recession, it may take a year or so before spreads meaningfully widen (Note: spreads widen when bonds cheapen relative to Treasuries or some other standard benchmark). Thus, non-financial sector balance sheets seem on the surface to be supportive of corporate bonds, but over time, this will change.
The high yield earnings backdrop will deteriorate as U.S. economic stimulus subsides; simultaneously, fallen angels (former investment grade companies downgraded to junk status) will distort the financial health of sub-investment grade companies. For example, Ford Motor Company debt was recently downgraded by Moody’s credit rating service to one notch above junk and S&P’s credit rating service has Ford on watch for a downgrade. More than 40% of corporate investment grade bonds are BBB, and the investment grade market is larger than ever; a downgrade wave could swamp high yield supply and cause spreads to widen (bond values drop when spreads widen) considerably. To date, the tight supply of high yield bonds within a growing investment universe has kept demand relatively strong and spreads tight as junk issuers have in many cases gone to the loan market or other venues for financing rather than the bond market.
The real corporate balance sheet threat comes on two different fronts from technology, not the economy.
- Technology and technology companies are directly competing with traditional retail, financial, manufacturing, and consumer goods companies
- Traditional companies will have to spend a huge amount of their resources to become and stay technologically savvy
Direct competition from technology companies and startups has caused the demise of many companies, including retail companies, stores, manufacturers, and REITs through online shopping competition from Amazon, Walmart.com, Etsy, Wayfair, Dollar Shave Club, Overstock, Wish, Helix, and a slew of other online and tech savvy competitors; as reported by CBInsights, every company needs to “conceive, execute and scale growth strategies” in the coming “digital revolution”*. Sear’s inevitable bankruptcy should surprise no one when it occurs. In addition, drone and self driving companies will compete with traditional transportation companies and 3D printing will disrupt traditional manufacturing.
The expense for traditional companies to keep up with the tsunami of new technology has been a boon for tech companies like SalesForce and CyberArk and consulting firms like Accenture and CACI. In 2013 Gartner research stated that “Every company is a technology company.”*** Forbes magazine reiterated the same thoughts in 2017**** and it has been echoed many times. Publicly-traded companies have increasingly mentioned robotics and related keywords on their earnings calls, up 2.5x since 2014 according to CBInsights research**, and as we know, robots are not cheap. Venture Capital firms are pouring billions of dollars into startups to directly compete with old world companies or sell competitive technology to them. It is a terrific virtuous circle until junk companies start hiccupping, unable to afford the latest and greatest competitive advantage.
Thus, even though we will have economic ebbs and flows which will cyclically affect high yield companies, the technological threat is a long term secular trend. A strong advisor can help you navigate between investments that take advantage of these technology trends and those that are threatened by them.
*https://www.cbinsights.com/research/events/
****https://www.cbinsights.com/research/robotics-mentions-grow-earning-calls/
Michael Ashley Schulman, CFA
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Disclosure: The opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.
