“Wealth does not pass three generations.” — Ancient Chinese proverb
“Most people do not have a problem with you thinking for yourself, as long as your conclusions are the same as or at least compatible with their beliefs.” — Mokokoma Mokhonoana
Duration or Credit Risk?
“Real estate and mortgage credit got us in so much trouble in 2007,” he said. “Next it’s going to be corporate credit, and the breakdowns are something we have to pay attention to.”
The above passage comes from an article in the Institutional Investor and quotes famed hedge fund manager Paul Tudor Jones. The article goes on to detail Mr Jones’s concerns around, what he describes as, a probable “global debt bubble”.
Global corporate borrowing reached US dollars 13 trillion at the end of last year — more than double the level prior to the Global Financial Crisis. The Paris-based Organisation for Economic Co-operation and Development (OECD) estimates that global corporations will need to repay or re-finance as much as US dollars 4 trillion in debt over the next three years.
Given the amounts involved, it comes as no surprise that Mr Jones is not alone in warning about the high levels of corporate debt being a potential systemic risk. Stanley Druckenmiller has been outspoken about it. Bank of America Merrill Lynch expects “corporates, not consumers or banks,” to be source of the next recession. Mr Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, cautioned in December 2018 that “the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors”.
PIMCO, one of the world’s leading fixed-income investment managers, being a little more sanguine than the aforementioned, started advocating a more selective approve to US corporate debt allocations at the start of 2018.
From PIMCO’s research piece published in January 2018:
Crucially, the share of the U.S. investment grade (IG) nonfinancial bond market that is rated BBB (i.e., the lowest credit rating still considered IG) has increased to 48% in 2017 from around 25% in the 1990s. Drilling down into the riskiest part of the BBB market segment, the universe of low BBB rated bonds is now bigger than that of all BB rated bonds (i.e., the highest-rated speculative grade bonds) combined.
[…]
We think investors may want to consider taking a more cautious and selective approach to BBB nonfinancial corporate bonds, particularly those in the low BBB rated segment where the risk of downgrades is higher and the room for error is lower. Of note, we are not advocating a generic underweight to BBBs, but rather suggesting a more selective approach in this environment. We still see opportunities in select BBB nonfinancials, especially in sectors with high barriers to entry, above-trend growth and strong pricing power.
PIMCO’s timing, in hindsight, was prescient. US corporate bond spreads bottomed, on a cyclical basis at least, in January 2018, having tightened through most of 2016 and 2017 on the back of a recovery in oil prices and then the enactment of the Trump Tax Cuts. Spreads blew out in the second half of 2018 as global risk-off sentiment gathered steam.
US Corporate BAA spreads to 10 year US Treasuries bottomed at around 150 basis points, approximately the same level as the pre-Global Financial Crisis low. Today, spreads are below 230 basis points, having partially retraced the move to above 250 basis points from late last year.
US High Yield spreads to 10 year US Treasuries bottomed at around 295 basis points, failing, however, to break their 2014 low of approximately 230 basis points. Incidentally, high yield spreads bottomed around 230 basis points prior to the Global Financial Crisis as well. Presently, spreads stand at approximately 390 basis points, having come in from over 530 basis points at the end of 2018.
A catastrophic event, widely experienced or one reported on extensively, can scar the collective imagination. The scarring can in turn heighten the sensitivity of individuals or the collective to signs pointing to the possible recurrence of said catastrophic event.
In the run up to the Global Financial Crisis, the investment community was long, very long, corporate credit — investment grade and high yield spreads were at or near multi-decade lows between 2005 and 2008. Following the Lehman bankruptcy, credit spreads spiked to multi-decade highs, leaving many investors nursing significant mark-to-market losses.
We are therefore not surprised that corporate debt is widely cited as a major risk to global markets in the event of a recession or another financial crisis.
What is often overlooked, however, is that investors, particularly institutional investors, were not long duration in the run up to the Global Financial Crisis — rather, it could be argued, they were quite possibly short duration. Using the 10 year US Treasury term premium as an indicator — the higher the term premium, the shorter the market is duration and vice versa — we can see term premium, in the below chart, rising rapidly in the two years running up to the Lehman bankruptcy, i.e. the market punishing duration.
As we all know, those who had the wherewithal to remain long duration were rewarded most handsomely soon after the collapse of Lehman.
Today, term premium for 10 year US Treasuries is negative — more than 70 basis points negative versus over 150 basis positive in 2007. If the next crisis or recession is unlike the last one, and it usually is, could it be that long duration, not long credit risk, is the pain trade?
When duration is punished, the entire spectrum of fixed income instruments feels the pain. In the next crisis there may be few places for coupon clippers to hide.
The Hypothetical Family Office
The story is clichéd but bears repeating.
A patriarch from humble beginnings and limited employment opportunities establishes a small business, works hard, starts employing relatives into the business and later his villagers. Benefiting from macroeconomic tailwinds and nonexistent competition, the business expands at a rapid pace and starts spitting out cash the patriarch continues to put back into the business.
As the patriarch grows older, he encourages his children to join the business. In this instance, the patriarch has three sons. The first, having grown up when his family had little wealth, shows no interest and is far more concerned with spending his father’s newfound wealth than increasing it. The second, having had a comfortable, if not luxury laden, upbringing, wants to prove his worth and is eager to join his father in his entrepreneurial pursuits. The third, still young and having experienced little else except luxury, pursues formal education at a school surrounded by the scions of other business magnates.
After decades of re-investing in the business and expanding it across the country, comes a point where the cash being generated by the business far overwhelms any of its investment needs. So the patriarch did, what any wealthy man in any developing economy has done over the last five decades, invests in real estate and then appoints his second son to manage and grow the real estate portfolio.
Real estate prices witness a parabolic rise over the next decade, driven by rapid population growth, urbanisation and lack of avenues to direct excess capital as local capital markets remain underdeveloped. The income from the family’s real estate portfolio exceeds that of the patriarch’s original business.
Come the late-1990’s, the third son graduates from university and joins the family business with fresh ideas and aspirations. He tries to convince his father and elder brothers to establish a family office and diversify wealth across geographies and asset classes. The second son averse to change, urges his father to stick to what they know and not to pursue the third son’s ideas. The third son, being his father’s favourite, however, is able to get his way. A family office is established, the second son continues to manage real estate and the third son is given a small amount of capital to diversify the family’s wealth.
As the first order of business, the third son feels that his family must gain some exposure to the dot.com boom. He connects with private bankers to help him allocate small amounts of capital to venture capital and technology funds. Just as the family’s capital is deployed into these funds, the tech bubble bursts and the funds are quickly marked down to zero. Mistake number 1.
The second son gains the upper hand and continues expanding the family’s real estate portfolio. The ageing patriarch with little ambition to manage his original business decides to take a step back, handing over the business to his sons. The sons enamoured by the world of investing, show little appetite for day-to-day operations. Instead, with the local capital markets starting to take off and growing public interest in stocks, the family appoints an independent management team, lists the business on the local stock market and enjoys a cash windfall. They are no longer millionaires, but multi-billionaires. It is now the mid-2000’s.
The losses from the tech-bubble long forgotten, the third son is given purview over some of the windfall profits. Erring on the side of caution this time, he engages the services of strategy consultants and investment consultants. Their advice is to allocate capital to big-name private equity and real estate managers. Capital is allocated to the likes of Kohlberg, Kravis & Roberts, Carlyle Group, JP Morgan and Goldman Sachs, amongst others, albeit it through private wealth management structures loaded with upfront and hidden fees.
The timing of allocations was not great but not spotting the hidden fees was criminal. Eventually, the returns were respectable gross of fees but atrocious on a net basis. Mistake number 2.
With large amounts of dry powder still at his disposal, the third son starts directly and aggressively investing the family’s wealth into the financial services sector — “look at the return on equity financial institutions enjoy,” he said.
Come the back end of 2008, Lehman Brothers goes bankrupt and those high returns on equity are history. Mistake number 3.
In 2011, the third sons starts investing small amounts of capital into biotechnology start-ups, directly not through funds — “we are investing alongside brand name venture capital funds without paying fees” he said. As it often happens, start-ups burn through cash and need to raise more capital. Not wanting to be diluted, the family participates in each subsequent round of financing. Come 2014 the handful of biotech start-ups are no longer small investments, rather the family is even the single largest shareholder in some instances.
In 2015, the biotech bubble pops and all of the start-ups invested in by the family prove to be duds. Mistake number 4.
In 2019, the family office allocated capital to venture capital funds for the first time since their late 1990’s debacle.
Everything in the above tale is true, except for the family office being hypothetical.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.