Author Topic: How could expanding corporate debt cause a harmful bubble?  (Read 749 times)

bthewalls

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How could expanding corporate debt cause a harmful bubble?
« on: February 17, 2020, 03:53:10 PM »
Hi all

Iím always curious of the cause of the next bubble, merely to try and understand more....before someone slams me, I find it interesting...thatís all.

I read in Forbes corporate debt is huge compared to 08/09...when Stimulation from QE and low interest rates starts to reduce severely whatís happens all this corporate debt?

Hope that makes sense....anyone explain effects of this to me?

Baz

Kyle Schuant

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #1 on: February 17, 2020, 05:14:26 PM »
Same as any debt bubble: borrowing more than can ever be repaid. At some point everyone publicly admits it'll never be repaid, then it all unwinds.


Shale oil company debt's probably the biggest single risk for the US right now. US government debt is a bigger joke, but it's backed by aircraft carriers. One day some country will launch a hypersonic missile out of a shipping container and sink a US carrier and then it'll all unwind. Until then the US govt can keep spending like a drunken sailor.

ChpBstrd

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #2 on: February 18, 2020, 10:16:40 AM »
The corporate debt unwinding scenario goes like this:

1) Shaky companies like Chesapeake energy, Ford, or GE leverage themselves to the max as an easy way to boost return on equity and EPS during a time when investors are reaching for yield. Under this capital structure, cash flow only covers interest payments if a few key assumptions all stay in place, such as low interest rates, no ratings downgrades, or commodity prices at a certain level. For example, a company may borrow at 4% to finance a project with 5% expected returns. If actual returns turn out to be 3%, or if the debt can only be refinanced at 6%, the project - or the company - will no longer make sense.

2) Key assumptions start falling for an increasing number of highly leveraged companies. Maybe their debt gets a surprise downgrade, or profits donít materialize, or the liquidity is not there at refinancing time. As a result, they are unable to roll their debts at a low enough interest rate so that their cash flow can cover interest. E.g. imagine if your mortgage had to be refinanced every couple of years, and the worse your financial picture became, the higher your interest rate went.

3) Such companies are downgraded and an increasing number seek bankruptcy protection. Investors start to demand higher interest rates from other companies they fear might get downgraded or go bankrupt. This causes assumptions to fall and debt costs to rise for a widening sphere of companies.

4) Investorsí bond portfolios start to underperform, setting off a stampede away from lower-quality corporate debt and toward treasuries. The spread between yields on treasury bonds and corporate bonds increases. E.g if treasuries previouslyyielded 2% and corporates 3%, now treasuries yield 1.5% and corporates 5%.

5) An increasing number of leveraged companies go bust because investors will no longer loan to them at rates they can cover with cash flow. I.e. they attempt to refinance their bonds which are coming due, and are unable to find sufficient liquidity to complete the refinance. Therefore, when they must pay back hundreds of millions in maturing bonds and donít have the cash, their only choice is bankruptcy or a negotiated default/restructuring. Simultaneously, interest costs increase even further for lightly-leveraged corporations, causing their profitability to drop and their expansion plans to be halted.

6) As corporate assets start to be shut down and liquidated, economic growth falls. Everything goes on sale and unemployment rises. The pace of bond defaults accelerates. This all creates a further feedback loop causing investors to demand more interest from their bonds. Spreads widen, causing corporate bond portfolios to lose even more. 


It is very hard to successfully time the market on these things. Unusually high leverage has been a market feature for years, and the commodity bust of 2016 failed to ignite a predicted wave of defaults and higher interest rates. Imagine being the investor who has been sitting in treasuries for the past 4 years waiting for the business cycle to turn, despite plenty of good-sounding reasons to do exactly that! Agony!

MaaS

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #3 on: February 20, 2020, 03:45:30 PM »
The corporate debt unwinding scenario goes like this:

1) Shaky companies like Chesapeake energy, Ford, or GE leverage themselves to the max as an easy way to boost return on equity and EPS during a time when investors are reaching for yield. Under this capital structure, cash flow only covers interest payments if a few key assumptions all stay in place, such as low interest rates, no ratings downgrades, or commodity prices at a certain level. For example, a company may borrow at 4% to finance a project with 5% expected returns. If actual returns turn out to be 3%, or if the debt can only be refinanced at 6%, the project - or the company - will no longer make sense.

2) Key assumptions start falling for an increasing number of highly leveraged companies. Maybe their debt gets a surprise downgrade, or profits donít materialize, or the liquidity is not there at refinancing time. As a result, they are unable to roll their debts at a low enough interest rate so that their cash flow can cover interest. E.g. imagine if your mortgage had to be refinanced every couple of years, and the worse your financial picture became, the higher your interest rate went.

3) Such companies are downgraded and an increasing number seek bankruptcy protection. Investors start to demand higher interest rates from other companies they fear might get downgraded or go bankrupt. This causes assumptions to fall and debt costs to rise for a widening sphere of companies.

4) Investorsí bond portfolios start to underperform, setting off a stampede away from lower-quality corporate debt and toward treasuries. The spread between yields on treasury bonds and corporate bonds increases. E.g if treasuries previouslyyielded 2% and corporates 3%, now treasuries yield 1.5% and corporates 5%.

5) An increasing number of leveraged companies go bust because investors will no longer loan to them at rates they can cover with cash flow. I.e. they attempt to refinance their bonds which are coming due, and are unable to find sufficient liquidity to complete the refinance. Therefore, when they must pay back hundreds of millions in maturing bonds and donít have the cash, their only choice is bankruptcy or a negotiated default/restructuring. Simultaneously, interest costs increase even further for lightly-leveraged corporations, causing their profitability to drop and their expansion plans to be halted.

6) As corporate assets start to be shut down and liquidated, economic growth falls. Everything goes on sale and unemployment rises. The pace of bond defaults accelerates. This all creates a further feedback loop causing investors to demand more interest from their bonds. Spreads widen, causing corporate bond portfolios to lose even more. 


It is very hard to successfully time the market on these things. Unusually high leverage has been a market feature for years, and the commodity bust of 2016 failed to ignite a predicted wave of defaults and higher interest rates. Imagine being the investor who has been sitting in treasuries for the past 4 years waiting for the business cycle to turn, despite plenty of good-sounding reasons to do exactly that! Agony!

What a great post.

I'd just add that in addition to unemployment stunting demand, the companies going bankrupt stop paying for goods and services from sound companies. The sound companies will generally be fine, but earnings freefall.

7) We're finally free from the outdated legion of zombie businesses and a new generation of better businesses begins.

hodedofome

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #4 on: February 21, 2020, 11:08:56 AM »
Same as any debt bubble: borrowing more than can ever be repaid. At some point everyone publicly admits it'll never be repaid, then it all unwinds.


Shale oil company debt's probably the biggest single risk for the US right now. US government debt is a bigger joke, but it's backed by aircraft carriers. One day some country will launch a hypersonic missile out of a shipping container and sink a US carrier and then it'll all unwind. Until then the US govt can keep spending like a drunken sailor.

It's not quite as simple as that. The US has monopoly power over it's debt. It's denominated and paid for in US dollars (which the US has monopoly control over). China can demand to sell all the treasuries it owns, but those treasuries are sitting on a server at the Fed. The Fed can just say "sorry, go stick it" and they can't do a darn thing about it, short of sending that missile you talk about. And if other countries stop wanting to buy our debit, the Federal Reserve can come in and buy virtually unlimited amounts of debt with money that it prints itself.

The US is not constrained by the amount of money it can borrow, but rather by inflation. At some point (and we don't really know what that point is), printing and spending above and beyond natural economic growth will create inflation. And too much inflation is a bad thing. However, we aren't in that scenario right now. Inflation is low in the US, and in places where populations are shrinking (like Japan), deflation is the problem and the government can't create enough inflation, even though they've been trying for 25 years.

Plenty of folks have been calling for inflation and even hyperinflation because of our debt, for years and years. Maybe one day they will be right. And maybe we'll be long and dead before that happens. Holding gold hasn't been a good investment the past 10 years. The past 20 years it's done better than the S&P 500, but only because 20 years ago was the exact top of the tech bubble.
« Last Edit: February 21, 2020, 11:11:30 AM by hodedofome »

ChpBstrd

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #5 on: February 21, 2020, 02:34:48 PM »
Same as any debt bubble: borrowing more than can ever be repaid. At some point everyone publicly admits it'll never be repaid, then it all unwinds.


Shale oil company debt's probably the biggest single risk for the US right now. US government debt is a bigger joke, but it's backed by aircraft carriers. One day some country will launch a hypersonic missile out of a shipping container and sink a US carrier and then it'll all unwind. Until then the US govt can keep spending like a drunken sailor.

It's not quite as simple as that. The US has monopoly power over it's debt. It's denominated and paid for in US dollars (which the US has monopoly control over). China can demand to sell all the treasuries it owns, but those treasuries are sitting on a server at the Fed. The Fed can just say "sorry, go stick it" and they can't do a darn thing about it, short of sending that missile you talk about. And if other countries stop wanting to buy our debit, the Federal Reserve can come in and buy virtually unlimited amounts of debt with money that it prints itself.

The US is not constrained by the amount of money it can borrow, but rather by inflation. At some point (and we don't really know what that point is), printing and spending above and beyond natural economic growth will create inflation. And too much inflation is a bad thing. However, we aren't in that scenario right now. Inflation is low in the US, and in places where populations are shrinking (like Japan), deflation is the problem and the government can't create enough inflation, even though they've been trying for 25 years.

Plenty of folks have been calling for inflation and even hyperinflation because of our debt, for years and years. Maybe one day they will be right. And maybe we'll be long and dead before that happens. Holding gold hasn't been a good investment the past 10 years. The past 20 years it's done better than the S&P 500, but only because 20 years ago was the exact top of the tech bubble.

Itís fair to say the US dollar is the USí main export.

bthewalls

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Re: How could expanding corporate debt cause a harmful bubble?
« Reply #6 on: February 21, 2020, 03:52:40 PM »
Maas and others, thanks for detailed explanation

Baz