BlackRock, the world’s largest provider of ETFs, has $6.3 trillion in AUM

After years of central bank stimulus, suppressed bond yields have finally started to rise around the developed world, with the recent tear in 10-year Treasuries attracting a bulk of attention. However, the world of corporate bonds might be more intriguing. After years of lows not seen in decades, investment-grade yields have begun to tick up: from December to February, Moody’s Aaa and Bbb yields rose 31 and 29 basis points, respectively.

Thus far, rising yields have been mostly attributed to concerns about inflation and rising interest rates. But, as we continue to ride the second-longest economic expansion on record, shouldn’t the potential for rising default rates receive some attention as well? Such a rise in defaults would serve as a major headwind for corporate bonds, especially in an environment already characterized by growing concerns over the removal of stimulative central bank policy. In this piece, we’ll explore the possibility that we are indeed due for a correction in corporate bonds, and specifically the ETFs that track them.

Leverage

One way to gauge the overall health of private sector balance sheets is to look at the extent to which firms finance through equity versus debt. In general, higher leverage is associated with higher default risk — for instance, the Merton Model (as it is used in practice) states that the probability of default for a firm should increase as its fraction of debt in the capital structure increases. So, we should expect an economy with more leverage to see higher default rates, all else equal.

Corporate credit market debt as a proportion of equity looks relatively low by historical standards, standing at 33.20 percent in October 2017 (the long-run average since 1958 is 54.67 percent):

However, if we account for the effects of stretched equity valuations, we get a different picture (see above). Multiplying our credit/equity ratio by the ratio of that month’s Cyclically Adjusted Price Earnings Cape Ratio (CAPE) to the long-run average since 1881, we find that the current adjusted ratio, at 60.96 percent, stands above the adjusted long-run average (since 1952) and median of 57.12 percent and 52.29 percent, respectively.

This suggests that stretched equity valuations may partially be masking the extent to which corporations are relying on debt as a source of finance. If valuations come back down to earth (which we’ll talk about below), we can expect to see higher corporate debt/equity ratios which, all else equal, should increase default rates.

Pressure may also come from the debt side; absent any major change in economic conditions and/or monetary policy, interest rates should in general rise in the developed world over the next few years, which will likely drive growth in firm’s debt service payments. As a result, we may see an assault from two fronts, with falling equity valuations hurting firms’ ability to raise equity finance on favorable terms just as rising interest rates make it more expensive to take out debt and roll over current debt. In such a scenario, we can expect to see rising debt/equity ratios and an uptick in default rates, as well as an increase in credit spreads, which currently stand at multiyear lows (see below).

Growth and Valuations

Despite corporate debt reaching 45 percent of U.S. GDP, many investors remain unworried, looking to low borrowing costs, corporate tax cuts and a stimulative federal budget. Theoretically, our CAPE-adjusted metric above could be flawed, with higher equity valuations simply pricing in more private sector growth in the future, meaning that valuations are not actually masking leverage and that cash flows will grow fast enough to meet rising interest payments. If this were true, the standard debt/equity ratio would make more sense.

However, Robert Shiller (who developed the CAPE ratio) has found that there is zero correlation between the CAPE ratio and the next ten years’ real earnings growth. Furthermore, “real earnings growth per share for the S&P Composite Stock Price Index over the previous ten years was negatively correlated (-17% since 1881) with real earnings growth over the subsequent ten years,” which means that “good news about earnings growth in the past decade is (slightly) bad news about earnings growth in the future.”

From a historical perspective, corporate profits are already very high as a portion of GDP. And debt, rather than being used to finance productive investment and aggregate demand-catalyzing wage gains, is being largely used to finance share buybacks and non-organic growth initiatives like M&A (for example, last week CVS issued $40 billion in debt to help fund its acquisition of Aetna). This suggests that corporate earnings don’t have much room to grow and likely cannot be relied upon to provide a cushion against rising debt levels and interest payments. It also implies that current equity valuations are stretched, artificially suppressing debt/equity ratios and hiding leverage.

And if labor does eventually gain a greater share of economic prosperity (which seems inevitable with the share of profits going to labor at historical lows) we could see a scenario in which firms are squeezed by both 1) rising wages and 2) Fed tightening as a response to those rising wages.

It seems that low interest rates and high equity valuations are masking the extent to which firms are relying on debt. Both won’t last, and as a result, firms (especially ones that rely on shorter-term debt) could see themselves struggling to meet rising interest payments just as they are forced to sacrifice some share of profits to labor. If we consider the fact that recent debt has been channeled into less productive uses (share buybacks, industry consolidation), it seems less likely that rising economic tides will be enough to “lift all boats,” and more likely that some firms’ over-reliance on debt will be exposed. We would expect higher default rates and risk premiums as a consequence.

Volatility

Earlier, we referred to the Merton model and its relation between leverage and default risk. In practice, a simplified version of the model is usually used:

“Distance to Default” = (1-(D/V)) / (σv √ T)

Basically, the risk of default will increase with leverage as well as the firm’s return volatility σv . And market volatility is just starting to pick up, as seen in the recent surge in VIX:

Recent, historically-low levels of market volatility will not last — and models predict that such a rise in volatility will lead to a rise in perceived default risk, which should increase the risk premium on corporate bonds, as well as the spread on investment- and speculative-grade bonds. It is worth noting that leveraged funds were net bullish on VIX on March 6th for the first time since February 2016.

The Role of ETFs and Other Passive Bond Instruments

Could the proliferation of passive bond investing have encouraged this debt buildup? The Bank for International Settlements (BIS) recently found that firms’ weighting in the BAML Global Broad Market Corporate Index had a much closer relationship with their leverage than their size. This suggests that the rise of passive, index-tracking bond investing has allowed firms with higher leverage and risk to continue receiving easy financing.

It is likely that many of those who invest in index-tracking bond funds and ETFs do not analyze every individual holding (particularly retail investors), much like investors in pre-crisis mortgage-backed securities did not tend to analyze individual mortgages within the securities. And, by nature, firms that issue a lot of debt will receive a higher weight in their indices, since they increase their debt outstanding relative to other firms. But, without investors analyzing these individual firms, and with ETFs and passive funds simply trying to properly weight holdings to match the the broader market, these firms won’t necessarily be “punished” by investors demanding higher yields to compensate for higher risk (since leverage = more risk). Instead, investors pour money into passive instruments (bond-focused ETF’s AUM have grown 25% annually over the last five years), with many failing to discriminate against individual firms within the index. As a result, they give more money to firms with more debt (who are weighted more highly) and less money to firms with less debt (who receive less weight). Passive bond investors may unknowingly have their investments biased towards the riskier firms within the indices they invest in.

Bond ETFs do seem to be largely attractive to those passive investors who want some reliable income and just want to track the market and “diversify” without evaluating individual firms’ health. And, while passive investing has its benefits, when these investors put their money in these vehicles rather than actively managed ones, there’s no one really there to evaluate individual firms — so even riskier firms receive adequate demand for their debt, which may even prop up their bond prices and keep borrowing costs low, temporarily hiding capital-structure problems. This means it is quite possible that the bond prices of some firms, especially riskier ones with more leverage, are trading at higher prices than is warranted by fundamentals.

So, what would happen to these corporate bonds and the investment vehicles that track them if investor sentiment changes (whether due to an uptick in default rates, falling equity valuations, slowdowns in economy-wide or earnings growth, interest rates rising faster than expected, etc.)? We can imagine that, in an asset class marked by rapid inflows, rapid outflows are in the realm of possibility. Indiscriminate investing (with regards to the individual firms within an index) means that indiscriminate withdrawals could result, possibly resulting in a “run” on some ETFs. Such periods of rapid withdrawals and overreaction could result in inflated ETF prices seeing an excessive correction, resulting in depressed prices. We would expect this type of “panic” selling to be most prevalent with speculative grade bonds, due to their risk profile; but, whether an ETF experiences a run would be dependent not only on its holdings (for example, whether its an AAA corporate bond fund or a CCC/speculative grade fund), but also on the type of investors holding that ETF, since retail investors tend to be more prone to sudden changes in sentiment than institutional investors. Bond ETFs that are characterized by high retail ownership should be more susceptible to rapid selling.

Conclusion

It seems a relatively likely possibility that corporate bonds are overvalued, despite the recent surge in yields. Two explanations (not mutually-exclusive) were offered.

First, inflated equity valuations might be hiding the extent to which firms are relying on debt relative to equity, something which should increase economy-wide default risks. Rising corporate debt levels are dismissed largely due to economic and earnings growth, corporate tax cuts, and low borrowing costs. However, high valuations don’t imply solid earnings growth in the future. Corporate tax cuts should certainly help the private sector, but profits are already a very high share of GDP, and in many cases capital isn’t being channeled into the most productive uses. Additionally, profits that translate into wage increases would likely contribute to Fed tightening, making it harder for firms to borrow and service debt in a world that will already see the withdrawal of central bank stimulus over the next few years.

Second, rapid and partially indiscriminate flows into bond ETFs might be depressing yields, leading to overvaluation on its own, but also reducing borrowing costs for riskier firm and postponing the “day of reckoning.” In other words, investors may not get compensated enough for default risk on bonds that are already overpriced, and firms can avoid overarching debt problems as long as their interest payments are low. The fact that inflows into bond ETFs have resembled“hot money” flows means that these ETFs could also see a sharp reversal of investor funds. As a result, there could be a rapid correction, or even overcorrection, in corporate bond markets.

With strong bank capital cushions resulting from post-crisis regulations, it is unlikely that the effects of such a correction would reverberate through the financial system. It would likely be a relatively isolated event, with some effects on valuations in other markets.

Appendix: Adjusting the Credit/Equity Ratio with CAPE

Credit/equity ratios, while a good indicator of leverage in the private sector, paint an incomplete picture as they are necessarily influenced by the level of valuations in equity market — when valuations are stretched, firms’ indebtedness will be understated, and when valuations are depressed, indebtedness will be overstated. To account for this, we multiplied quarterly credit market debt/equity ratios by the ratio of that month’s Cyclically Adjusted Price Earnings (CAPE) ratio to the long-run average of 16.84, or:

Adjusted Ratio = (Credit Market Debt / (Market Value of Corporate Equities / (CAPE / 16.84)))

Adjusted Ratio = (Credit Market Debt / Market Value of Corporate Equities) X (CAPE / 16.84)

With:

Standard Ratio = (Credit Market Debt / Market Value of Corporate Equities)

The adjusted ratio should reflect equity valuations — for periods with high CAPE ratios, the adjusted ratio will be higher than the standard ratio, and for periods with low CAPE ratios, the adjusted ratio will be smaller than the standard ratio.

Looking at the speculative grade default rates from 1970 until 1993, we find that defaults are much more highly correlated with the adjusted ratio than the standard ratio (R-squared of .32 compared to essentially zero).