Investors Are Main Lenders To U.S. Businesses, But May Not Understand Risks

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageFaced with regulatory constraints and stricter guidelines, bank lending to businesses declined since the financial crisis. The business sector filled the void by issuing bonds, which were quickly swallowed by yield-seeking investors. This amounted to a transfer of lending risk out the banking sector and into the investor class. This is good news for the banks, which are now in better shape, especially in the U.S.. The bad news is that, unlike banks, the investor class has no safeguards if something should go wrong. Also unlike banks, the average bondholder is ill-prepared to ascertain credit risk. And there are signs that the risks bond investors face are increasing.

There is no doubt that the role of investors as lenders to businesses has become more prominent. In the U.S., for example, companies in the non-financial sectors now have well over twice as many bonds than loans outstanding. In Europe, although bonds are not a widespread source of private sector financing, the proportion of bonds still nearly doubled with respect to loans since the financial crisis.

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Another reason to worry is that U.S. corporate bonds rated at BBB by Standard and Poors represent the largest group by far, at 37% of all non-financial corporate bonds outstanding, or $2.7 trillion. This is a credit rating category at the very bottom of the “investment grade” ladder. Bonds downgraded from this BBB category fall to the “non-investment grade” land where many investors are forbidden from entering. Thus, a downgrade that pushes a bond across that divide triggers selling that can drive the bond price even lower.

There is a large wave of bonds maturing in the next five years, which could be as large as $10 trillion globally according to the McKinsey Global Institute report. These bonds will be replaced with new ones that would be more costly if they are issued at higher rates than the ones maturing. This is likely to be the case, since interest rates are going up. Bonds at the threshold of investment grade quality could easily fall into the “junk” world.

There is also the issue of bond liquidity. The McKinsey report reminds us that “buying and selling corporate bonds often requires a phone call to a trading desk at an investment bank, and there is little transparency on the price the buyer is quoted”, a feature that can seriously curtail bond liquidity if a credit event were to take place.

Mutual funds – the largest holders of corporate bonds – can easily withstand the first wave of redemptions with their cash holdings, but because many funds hold similar positions, a selling wave could pose a problem when everyone is on the same side of the trade. Both practitioners and academics like Caitlin Dannhauser of Villanova University and Saeid Hoseinzade of Suffolk University have studied this point in depth.

A liquidity crisis is more likely today, when trading desks at investments banks that used to hold large bond positions are now restricted from doing so. Bond holdings of primary dealers, for example, have steadily declined and are now about a fifth of what they were before the financial crisis, even as the outstanding amount of bonds more than doubled.

Investors are now much more exposed to business lending risk because of their large holdings of corporate bonds, a risk that will increase if economic conditions suffer. While the economy is currently firing on all cylinders, it is vulnerable to the tightening efforts of the Federal Reserve, a slowing global economy and the risk that today’s trade disputes could turn into a full-scale global trade war.

Any of these issues could push some corporate bonds over the non-investment-grade category, severely affecting bond prices. While it is unlikely that bond weakness could turn into a broad crisis, bondholders will be hurt. They need to pay close attention to the risks they face, especially because nobody will be there to help them if their investments sour.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Business sectors are set for massive changes this fall

By Path Financial President and Chief Investment Officer Raul Elizalde

2018-06-04 14_05_27-Sector ETFs Are Set For Massive Changes This FallThe Global Industry Classification Standard (GICS) is a taxonomy system developed by MSCI and Standard & Poor’s that organizes companies into 11 economic sectors. This classification is applied to sector indices, which are in turn used to build ETFs and mutual funds that track them.

But the GICS system was created almost 20 years ago, and the world has changed a lot since then.

Facebook, for example, is no longer the online curiosity it was when it first started. It is now a huge delivery system for content, marketing and advertising. So it no longer seems appropriate that it should coexist in the same “information technology” box as Akamai, for example, which builds internet delivery networks and focuses on security and reliability.

To accommodate these changes the good folk at GICS have produced a preliminary list of more than 200 companies around the world that will be reclassified to reflect better what they actually do today. A final list will be published in July, and changes will be effective in September.

The technology sector will lose many big names to a new communications sector (a rebranding of the current telecommunications sector) such as Alphabet, Google and Twitter. Consumer discretionary will lose Comcast, Disney and Twenty-First Century Fox to communications as well.

These huge changes will fundamentally change the technology, communications and consumer discretionary sectors. Investors unaware of these changes will be in for a big surprise.

For example, the market cap of the communications sector will jump from today’s $1.7 trillion to perhaps as much as $10 trillion, according to a study from State Street, one of the largest ETF providers. Consumer discretionary and technology will shrink.

Additionally, as the State Street study points out, communications will be far more correlated to the S&P 500 than before. It will also include 13 stocks in the top 50% of returns in 2017, a huge change for a sector that today has a large proportion of high-dividend, defensive stocks. Furthermore, historical studies of sector volatility and correlation will be rendered largely useless. Investors who strive to build efficient portfolios using that data will find themselves in the dark.

ETFs, which have been the investors’ vehicle of choice to track indices, will be particularly affected. For example, State Street’s SPDR Technology Sector XLK, Consumer Discretionary XLY and Telecommunications XTL that track the S&P Select Sector indices (built around GICS) will be revamped to mirror the new compositions.

Vanguard, which also has sector ETFs (the Technology VGT, Telecommunications VOX and Consumer Discretionary VCR) structured as a class of their mutual funds adopted an interesting approach. Between May and September they will track custom MSCI Investable Market Transition indices to avoid sudden changes to the funds, in lieu of the current MSCI Investable Market Indices.

Fidelity’s U.S. sector ETFs track U.S.-only versions of the MSCI Investable Market Indices, which will change as well. On the other hand, some of Blackrock’s US-only sector ETFs will be unaffected, such as the Technology IYW and the Telecommunications IYZ, because they track US-only Dow Jones Sector indices that are not aligned with GICS. Adding to the confusion, Blackrock’s global sectors ETFs such as the Global Telecom IXP are linked to GICS definitions, and will change.

This is enough to make any investor’s head spin. What investors must remember is that some of the sector funds they use today may no longer represent their investment objectives after September. Keeping abreast of the upcoming changes will go a long way to avoid surprises down the road.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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