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.

first graph

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.

——————-

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.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather

2 Reasons Why Demand For Stocks Will Fall

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageTwo sources of demand that contributed to driving up stock prices are going away.

Strong buying came in the last few years from the very companies who issued those stocks. Finding it cheaper to borrow money than pay dividends, they issued a large number of corporate bonds and used the proceeds to buy back significant portions of their outstanding shares.

Alongside companies buying stocks were retail investors who just wanted income, but could not find it anywhere as interest rates hovered around historical lows for years.

There are indications, however, that both reasons for buying stocks are becoming less compelling.

To begin with, there are fewer shares. This was the logical result of having interest rates at historical lows, which resulted in companies buying back stocks. This gave more fuel to an already booming stock market.

today first graph

According to the Fed, a net value of $3.1 trillion of corporate equity was retired by repurchases and mergers & acquisitions since 2011. This enormous amount is comparable to the entire GDP of Germany. The number of shares in the S&P 500 calculated by Standard & Poors shows the same trajectory as the Fed data. And the first quarter of this year set a new buyback record, even as rates rose.

But the feverish pace of repurchases may be starting to ease.

today second graph

The 2-year US Treasury rate is now above the average dividend yield of S&P 500 companies. Some companies may still be able to issue bonds at cheaper rates than their dividends, but the margins are getting thinner and fewer can still do this profitably. This may be the reason why the portion of companies retiring more than 4% of their outstanding stock fell to its lowest level since tracking started in 2014. If rates continue to climb, we believe that this portion will fall further.

Additionally, conservative retail buyers who had gravitated to stocks as the only source of income are now able to access the safety of bonds that offer higher yields. While rates are still relatively meager by historical standards, they are now at least at par with inflation. Investors who until recently had no choice other than dividend stocks to produce income may be warming up to bonds, thus reducing another source of demand for stocks.

Stocks went up for various reasons in addition to corporate buybacks and dividend-seeking retail investors, but there is no doubt that both have played an important role in driving up prices. As rates return to more normal historical levels, these two sources of demand may well evaporate. While this may not be enough to sink the market, at the very least it paves the way for higher volatility in the months ahead.

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

——————-

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.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather