Profiting from “peak cycle” in corporate debt demands a hedged investing mindset
2020 will be remembered for a lot of things. First and foremost is the human tragedy, strife and uncertainty that has consumed our daily lives.
From an investor’s point of view, 2020 has also been a continuation of a pattern that may be little more than a sound bite. But it should be more than that. I am talking about the accelerating pace of growth of corporate debt.
Corporate debt bubble – it’s here
Some U.S. households may actually be increasing their savings rates and lowering debt during the crisis, if they are not caught up in the forced unemployment that has stricken so many. Corporations, on the other hand, are ramping up their borrowings and have created a debt bubble among those businesses that operate in the public markets.
This is NOT a new issue. 2020 did not force this upon corporations. It is the latest cycle of corporate indebtedness that has reached a crescendo.
One way to make this clear is to look at total corporate debt as a percentage of U.S. Gross Domestic Product (GDP) at different points over the past 70 years. Here’s a quick look, based on year-end data from Ycharts.com:
In 1951, U.S. Corporate Debt as a percent of U.S. GDP was about 22%. Since that time, it has risen as high as 50, in March of 2008. After the financial crisis of that year, it ducked down below 40 briefly. As of the end of 2019, it stood at 46.6%, near its recent peak for this cycle.
High debt levels, in context
What does all of this mean? Well, to put it in context, past peaks in the level of corporate debt versus GDP occurred at these points in time:
1974, 1990, 2001, 2008. In other words, corporations raise more and more debt to try to grow (or just survive). Then, they reach a point where the economy can’t handle it, and a recession follows. As you might surmise, being at “peak debt” when the economy rolls over is not the greatest timing. That appears to be where we are now.
This is a long-term cycle, and it is a process. And, investors may be able to blow it off as long as the Fed continues to make it look like everything is going to be OK. They do that by essentially standing behind a lot of corporate debt that, if left to its own devices, would collapse like a 20th Century Boston Red Sox club in September (sorry, haven’t had my baseball season yet, so a little rusty with the sports analogies).
As this chart shows, corporations have been jacking up their balance sheets with debt at a rate far in excess of what the economy is growing at. This is just before the early 2020 recession started.
So, what’s the big deal?
Every investor, if not every citizen, should understand that this is not sustainable. And, it is one of those things that you might just hear in a movie years from now, about how this was going on, but no one cared. I think you should care.
How does this impact the way you look at your portfolio? Simply put:
Corporate bonds are full of landmines
High yield corporate bonds are even more treacherous
Despite this, bond holders outrank stock holders when the bubble bursts, so be careful owning stocks that look “cheap” but are just bouncing up from depressed recent lows. Many are cheap for a reason.
Know that there are ways to profit from the eventual implosion in corporate credit. But it requires a hedged investing mindset, and looking at how you generate investment returns in a very different way than you used to.
After all, this is “peak cycle” for corporate debt. That should ring the bell for all investors to double-check where the no-so-obvious risks are in their portfolios.