Debt is like NYC Tap Water: Cheap and Plentiful

By: Uri Estrin - October 20, 2020 09:49am EST
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Everyone is so fixated on yield,  they have forgotten about the preservation of capital and the reward required to compensate for such risk
Everyone is so fixated on yield, they have forgotten about the preservation of capital and the reward required to compensate for such risk

Nothing in New York is cheap, probably with the exception of tap water. Debt – and more specifically bonds - have become like NYC tap water. There is just so much of it being issued, by anybody and everybody and at such low rates historically, there is as a result, no realistic valuation.

We are in extraordinary times, and with so much stimulus money pulsing through the system, money is even cheaper and investors are in search of yield. Unfortunately, everyone is so fixated on yield, they have forgotten about the preservation of capital and the reward required to compensate for such risk. Risk seems to be passé.

Debt used to be an instrument not taken lightly. If you took on debt, you needed to think hard about the consequences of not paying it back. Through the mid 19th century, most of Europe still had debtor’s prisons. If you couldn’t pay your debts, you worked in a prison workhouse, your labor contributing to your debt payoff. In some countries today this still exists.

Yet we have seen countries and corporations issuing bonds at such an accelerated rate. Much of this debt is taken on to finance missing revenues – sort of as a stop gap – until supposedly things go back to ‘normal’.

Bonds, unlike say a consumer mortgage, are an interesting instrument. A borrower can issue a bond, pay the coupon (interest) – say bi-annually (but even the coupon can be deferred) - but no need to pay any capital. Long term bonds can have a life span of 30-years – a lot can change in that time. A mortgage on the other hand, obliges the borrower to pay off not only the interest portion, but a capital portion with each regular payment, until the end of the loan and the outstanding balance is zero. A bond defers all of the capital until maturation. When rates are as low as they are now, borrowers can take on an enormous amount of debt with very little repayment obligation. Additionally what borrows have been doing, instead of paying back the principal on maturation, having provisioned for the capital necessary to repay, they are ‘rolling over’ the original loan and taking ever more debt to pay debt. (Zero coupon bonds - made popular in the 1980s - were the epitome of deferred payment, with no interest payment and a balloon payment on maturity).

This is like spending on a 0% APR credit card, then getting another bigger credit card and doing a balance transfer – over and over. In vogue is to ramp up debt with a disconnect between total debt issuance vs revenue – and this is in large part had given a free pass because of low rates. The argument supports taking on more and more debt as sustainable, because small (in some cases zero or negative) interest payments won’t break the issuer. And without capital being repaid in a sense this is true. Credit rating agencies have seen to acquiesce.

But here’s the problem – somewhere down the line investors are going to lose a lot of money when some of the bad apples go rotten. The current status quo is like an old fashioned Ponzi scheme. As long as there are new buyers – new debt issuance – to roll over and payout the existing bond holders, the game can continue. But as soon as that new flow stops, the issuers are sitting in a quagmire, many of whom will not be able to repay the principle without rolling over a major portion of existing debt.

While we have seen some frenzied issuance – think Hertz, Carnival Cruises (read our article: Don’t underestimate the Fed’s Playbook) – where the hint of Fed backing no doubt bolstered the current wild issuance excitement.

But cracks are starting to appear and this does not bode well for the junk bond market, nor the corporate bond market even under all, but the highest grade.

UK’s Rolls Royce and Jaguar Land Rover have both sought new funding in the bond market recently. Rolls Royce is looking to raise £2bn, with coupons between 4.625% and 5.75% (2026/2027 maturity) – which is far above 0.875% on 6 year bonds, issued by them 2 years ago and far above market rates for European High Yields.

Jaguar Landrover issues $700M in notes, $200M more than anticipated, earlier this month but with a coupon of 7.75%, which is incredibly high given how far yield differentials between treasuries and high yield debt have fallen.

Viking Cruises, Carnival Cruises and American Airlines – all travel distressed industry players - have issued double digit yielding coupons, but Ligado Networks, a wireless telecommunications company which has already once been through bankruptcy, is prepared to pay 17.5% on part of its new bond issuance, hopeful to recapitalize and possibly prevent a second bankruptcy. These are early signs of doors closing on new bond issuance to some highly leveraged or distressed industry players.

Evergrade is a highly indebted China developer with more than $120B in debt. Instead of issuing debt to pay debt, last week they used a different approach and targeted to raise $1B in a new share offering. Evergrade said in a filing last week that it had raised $555m – short of its target – but enough capital to hopefully bring down it’s debt obligation.

Zambia is set to be Africa’s first recent sovereign default having not made their latest interest payments and it looks like Bahamas may not be too far behind, not to mention as few more smaller heavily indebted Sovereigns.

There is debt fatigue. While the notion that the borrower needs only to service the debt is misplaced. The reality is that one day the debt becomes so unmanageable, that even the servicing becomes unsustainable.

What about the US Government ? In theory Treasury borrowings could reach an unsustainable point too. But the US Treasury is in a very unique position (read our article: Why the Treasury Auction wasn’t so ugly). The debt is issued by the same structure that creates the currency. In theory, the Fed could buy all of the issuance of the Treasury and never default (Japan is buying almost 100% of its own issuance) – the result would be an entirely unproductive economy – but not technically a default. But the other thing investors seem to forget that if the US gets to that point, where will everyone else be? Zambia will have long defaulted and have joined the Argentina club, along with most of the developing world. Europe, China and Japan have even higher debt levels – so the US Treasury still seems to be the best bet in a bad neighborhood (read our article: Why we think treasury bonds are still a good buy).

If you are chasing yield but don’t think your bond issuer will still be standing, then you should probably be re-evaluating your position sooner, rather than later. Things are starting to move, which could accelerate rapidly, and not in a good way.

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