The Merchant of Venice

In 1596 William Shakespeare was hard at work in south London writing what was to become the Merchant of Venice. The play was first premiered in the Court of King James and received immediate acclaim. An instant classic, the plot centered around Shylock, a greedy moneylender and Antonio & Bassanio, a pair of desperate borrowers. As the story goes, Antonio and Bassanio become overextended and eventually ran into hard times, in this case, the loan cosigner’s collateral goes missing (their merchant ships lost at sea) and Antonio and Bassanio were unable to repay their loan to their lender, Shylock. Shylock has lost patience by the time Antonio and Bassanio produce the funds to repay. He rejects the repayment, refuses further lending, and famously demands in court for a “pound of flesh” as remuneration. It is from this conflict that we have our age-old drama, true to the Greek masters of old. The classical theater is a beautiful art for a variety of reasons. One of the most enduring and illuminating aspects of theater is its unique ability to give the audience insight into human nature. This is what the great classical Greek playwrights sought out to do and is one of the reasons why the Greek works have stood the test of time and are relevant over two thousand years later. What these enduring works continue to show us time and again is that human nature hasn’t changed all that much over the millennia. Flash forward to today. Over ten years into a bull market, and one of the greatest in modern history, one does not have to look hard to find expensive asset classes. From stocks and bonds to real estate and fine art record prices have become the norm and pricing has been pushed to historical highs based on any conventional valuation metrics. A decade of record-low interest rates has no doubt influenced excessive risk-taking and I will argue it has become most pronounced and has the most far-reaching implications through what has taken place in the corporate bond market. How the future unfolds will likely pit debtors and creditors in the same way Shakespeare observed over 400 years ago. Size of Corporate Debt Market By any metric, corporate credit has grown to a size unseen before. Whether as a percentage of GDP or relative to EBITDA, corporate credit has ballooned. Times have been good and a lot of this debt has been supported by increases in corporate profits. However, low interest rates and strong fundamentals have allowed corporate borrowers to lever up their balance sheets and go on a borrowing binge. With net debt to EBITDA at an all-time high, many issuers will be contending with serious challenges to service and repay their debt if they fall upon hard times. While the amount of corporate credit has exploded and borrowers have become more indebted corporate credit rating standards have been significantly lessened. The loosening of rating standards has no doubt helped fuel the rise in corporate debt. By some estimates, nearly 39% of the investment-grade investment universe would be downgraded to junk if historical rating standards were applied. Why is this important? For several reasons, corporate debt ratings carry significant importance in how the market behaves. Not only does a lower credit rating mean higher borrowing costs for the issuing company but the fact is that many corporate debt investors have rigid mandates which dictate what credit they can own and which credit they cannot own. As a result, many holders of investment-grade corporate credit are unable to own below investment grade paper. In the event that investment-grade paper is downgraded this part of the market turns into forced sellers. Today, even with looser rating standards the most vulnerable of investment-grade credit has grown to 55% of the investment-grade universe, up from just 17% in 2001 suggesting a large segment of the investment-grade market is vulnerable if a number of downgrades were to occur. Corporate Credit Valuations at All-Time High Looser rating standards and swaths of eager lenders have pushed corporate credit valuations to all-time highs. Both on an absolute and relative basis corporate debt has seen immense interest, largely spurred on by aggressive central bank policy which has in turn left yield-seeking investors starved and in search of return potential. The corporate debt market has been one of the largest beneficiaries of such behavior with borrowers able to issue ever-larger amounts of debt and at ever-lower prices. It wasn’t until December of last year that the market began to more closely scrutinize new issues, after several interest rate hikes by the fed earlier during the year. The market briefly seized up and the S&P 500 fell nearly 18%. The market has since rebounded with stocks and bonds finding new high points in terms of valuation. While valuations for both asset classes leave investors little room for error, the high valuations in corporate credit pose the greatest challenge and are yet another reason why investors must tread carefully. Number of Zombie Companies at All-Time High One prime example of the excesses that have formed in the corporate credit market is the buildup and proliferation of zombie companies. Today the number of so-called zombie companies (highly indebted companies that are unable to service or repay their existing debt through current earnings) is at an all-time high. Today 14% of companies in the S&P 1500 are considered “zombies”. This compares to a mere 2% in the 1980s. Many companies which under normal circumstances would have been forced out of business or to shutter operations have repeatedly found a lifeline and have been able to refinance their debt. And the proliferation of zombie companies is not isolated to the U.S. As interest rates have plumbed to new lows across the world so has the number of zombie companies risen across Europe and Asia. If and when financial conditions tighten, as they briefly did last December, these companies and their creditors will likely be the first to face a reckoning. International Ownership of Corporate Credit International investors, even more, starved of yield in their respective home countries have emerged as leading forces in the bidding up of corporate credit. This is laid bare by the fact that, despite a strong economy, since 2006 the net investment position of the U.S. has gone sharply negative. Much of the foreign capital has flowed into corporate credit and has done so on an unhedged basis as it has been cost-prohibitive for foreign currency investors to hedge their currency exposure (the cost of hedging would erode all gain from the corporate credit investment). All of the aforementioned phenomena occurring in the market come at a time when the market’s structure has changed dramatically. Regulations spurred on in the aftermath of the financial crisis of 2008 have forced banks, historically the leading providers of liquidity to the bond market, to reduce their inventories and change their balance sheets. The result is greatly reduced liquidity in the market which will serve to pronounce market dislocations when they occur. What tips things over the edge? Eventually, it may become clear to lenders, that companies which have become overextended and overleveraged, may not be able to repay their loans. The result will be a seizing up, potentially abrupt but also potentially gradually, of the credit markets. Starved of capital, zombie companies will no longer be able to plod along. Even productive businesses may see a tightening of financial conditions which will lead to less expansion and less growth. As a result, and in addition to rippling across market and lowering asset prices, companies heretofore which had plentiful access to capital will no longer be able to invest and expand like they were. Hiring will slow and unemployment may even rise which will feed through to the real economy and precipitate the next recession. Just as in the burst of the dot com bubble and the collapse of the mortgage market in 2008, excess in one area of the financial markets can spread very quickly. Low interest rate policy by central banks around the world is undoubtedly a major driver behind the bubble brewing in corporate credit as it is behind the run-up in all asset prices from real estate to venture capital and public equities. Investors, starved of yield have been forced into riskier assets in search of returns. Thus far credit has largely remained available and there have been few instances where creditors were not repaid their loans. If the laws of economics remain true then there will eventually be a time when this changes. The issues becoming apparent in corporate credit have been highlighted by many of the market’s leading fixed income commentators. What investors should do in the run-up and aftermath of the ensuing crisis has not been widely discussed. While I am not calling for a total meltdown in the stock and bond markets, I believe investors should be positioned conservatively and should exercise caution going forward. With equity valuations near historical averages and corporate credit spreads at all-time lows assets are priced with little room for error. Significant risks remain and investors would be well served by decreasing exposure to riskier assets which have done well and allocating capital to assets that will do well in tougher economic and market environments. Cash, conservative fixed income, real estate, and high quality/low debt equities all should do well and provide ballast and liquidity to a portfolio in the event of a downturn. The global macroeconomic backdrop that will follow the next downturn is hard to predict but we can be fairly confident that growth will be hard to come by. The long, grinding demographic trends in Japan and Europe will eventually become more pronounced in the United States due to the demographic trends already in place. This is not to mention China which faces a similar situation of demographic aging, the after-effects of 40 years of “one child only policy”. Interest rates will likely remain low in such an environment. The same type of high quality, sustainable cash flow assets prescribed above will likely be the best performing assets in the period that follows. For hundreds of years, Shakespeare’s work has been read and debated by the world’s leading literary critics and The Merchant of Venice was no exception. The creditors and lenders had their tussle and eventually, their dispute was resolved but not until they went through a period of hardship and excessive demands from Shylock. Today The Merchant of Venice is considered to be Shakespeare’s most controversial play for a variety of reasons. Debate rages on whether or not the work constitutes a piece of drama or comedy. Unlike The Merchant of Venice, when investors look back on the bursting of the corporate credit bubble there will be no debate that it was a tragedy. Creditors today may not get to extract a “pound of flesh”, as Shylock demanded 400 years ago, but corporate credit investors would be best served to tread carefully.