Total corporate debt as a percentage of U.S. GDP averaged around 15% from the 1990s through 2007. Since that time, however, the size of the corporate bond market has expanded to nearly 36% of GDP.
Toward the end of 2015, several high-yield funds had to close when that segment of the debt market experienced pressure due to the declining prices of crude oil and other commodities. Since then, the high-yield market has garnered a great deal of attention, but our research indicates investors need to look at the bond market in aggregate. Consider:
• Corporate debt outstanding has increased meaningfully since the global financial crisis, but investment grade companies — not high-yield — have been the key drivers of this trend.
• Commodity and energy-intensive industries have been responsible for 25% of the corporate debt issued since 2009.
• Overall, corporate balance sheet leverage has increased at the same time underlying fundamentals — and, in turn, debt service — have softened.
One way we analyze corporate debt outstanding is to look at its size relative to the U.S. nominal gross domestic product (GDP). For most of the period from the early 1990s through the start of the financial crisis in 2007, total corporate debt as a percentage of U.S. GDP averaged around 15%, ending 2007 at 20%. Since that time, however, the size of the corporate bond market has expanded to nearly 36% of GDP. The majority of this increase has been driven by investment-grade borrowers, who have taken advantage of low rates to fund share repurchases and acquisition-related activities.
Notable in recent years is the amount of debt that has been issued by companies whose fortunes are tied to commodities, where prices of energy-related products and metals have fallen dramatically in recent months. Since 2009, over 25% of corporate bond issuance has been tied to commodities. While stresses have become apparent in the high-yield bond market, commodity-oriented companies have yet to experience major credit losses, which we believe is a risk in 2016 and beyond.
In addition, many investment-grade borrowers, faced with slow economic growth during the post-crisis recovery period, have taken advantage of low interest rates to borrow money to fund share repurchases and acquisitions. These forms of “financial reengineering” can help boost earnings per share in the medium term, but they also pose a risk that economic conditions could deteriorate as balance sheet leverage is pushed higher.
Finally, we would note that corporate fundamentals have eroded along with the weakening global growth picture. Namely, revenues and measures of cash earnings are growing more slowly. This combination of rising balance sheet leverage and weakening growth in profitability suggests that the elements for a classic credit cycle are in place.
The potential for increased credit losses has thus risen for both banks and credit markets. JPMorgan recently acknowledged at its Investor Day that it will increase credit reserves on its energy loans by $500 million in the first quarter of 2016 and that there may be further losses if oil prices remain low for an extended period. Other banks with exposure to oil and gas companies have similarly acknowledged the potential for higher losses. We note, however, that the size of oil and gas lending is significantly lower than what mortgage and other consumer lending was prior to the great financial crisis in 2007. In addition, banks are much better capitalized and have more liquidity to deal with short-term stresses, thanks to the regulatory response to the crisis. In short, we believe the banking system is in good shape to deal with any potential credit losses that may come from oil and gas lending.
Despite these headwinds, bottom-up fundamental work can help identify good companies that are currently undervalued compared to their intrinsic values. In our opinion, we have been able to find compelling investment opportunities within the financial sector that are less exposed to the increased corporate credit risk we see. Ally Financial is an example of a consumer-oriented lender that is improving its earnings quality through cost cutting, balance sheet restructuring and expansion of its automotive lending platform. We also believe Intercontinental Exchange (ICE) has become attractive as it pushes its business model away from purely transaction-oriented revenues to subscription-based market data fees, which are much more stable.
As investors continue to navigate through more uncertain markets and increased corporate credit risk, we believe it is essential to seek out those investment opportunities that fit within a clear valuation framework and have catalysts for valuation realization.
Rob Stoll is executive vice president and research analyst at Institutional Capital (ICAP), a global value investment manager of U.S., non-U.S. and global portfolios.
