During the housing bubble days of 2003-2007, otherwise smart people justified the insanity with arguments like this: "There's no bubble. Borrowing is way up because homeowners are taking advantage of low interest rates. That's a good thing!"
Whoops.
Today, the justifications for bond mania sound eerily familiar. Don't worry about the so-called bond bubble, I keep hearing; debt issuance is only growing because companies are taking advantage of rock-bottom rates. Nothing to see here ...
I don't buy that. Insanity, as Einstein said, is doing the same thing over and over again and expecting different results. The housing bubble taught us that smart people will make stupid decisions when cheap debt gets dangled in their face. Two years later, with outrageously cheap debt being pushed on corporations, we're now expecting everyone to behave.
Over the past few years, households and consumers have done a pretty good job paring down debt, either by paying it off or defaulting on it. Corporations, on the other hand, have done just the opposite, bringing indebtedness to an all-time high:
That in itself isn't scary. But the amount of debt corporations are taking on in relation to assets and output most definitely is. Net leverage -- debt minus cash as a percentage of assets -- is now at nearly 50%, a modern record. According to Reuters columnist James Saft:
Compared to 1997, U.S. corporations are using about 20 percent more debt to produce the same dollar of profit, and this figure is before you consider the uncounted amount of off-balance-sheet debt corporations are responsible for. According to a PricewaterhouseCoopers survey, proposed accounting changes would increase by 58 percent the amount of interest-bearing debt the average corporation shows on its published balance sheets.
How and why could this happen? The short answer, in my opinion: because investors are short-term minded emotional creatures, and because they allowed it to.
When the financial crisis first struck in late 2008, it prompted a very rapid exodus from all fixed-income products other than Treasuries. In fact, most of the Federal Reserve's bailout maneuvers of 2008 directly responded to the corporate debt market shutting down. No one wanted to touch the stuff.
All of that changed in 2009. In part because debt markets rebounded so quickly, and in part because of disenchantment with the stock market, investors' fascination with debt went through the roof. Since early 2009, investors have plowed more than $600 billion into bond mutual funds, and bond ETF assets have more than doubled to $130 billion.
The result has been a bonanza for companies looking to go into debt. Companies such as Microsoft (Nasdaq: MSFT), Johnson & Johnson (NYSE: JNJ), and IBM (NYSE: IBM) have been able to issue debt at miniscule interest rates. Microsoft issued its debt at an interest rate of less than 1%. Sixty-eight companies in the S&P 500 average have stock dividend yields that exceed average corporate debt yields -- the most in 15 years.
At one point earlier this year, swap spreads turned negative for the first time in history, meaning that some private borrowers were considered less risky than the U.S. government. You can probably find a finance textbook somewhere that assumes this is mathematically impossible -- but it's the world we live in.
Scarier still is the quality of debt being issued. Junk bond issuance has reached an all-time high -- absurd, given investors' paranoia over the economy's strength. Year to date, companies owned by private equity investors have raised $17 billion of debt, solely to pay special dividends to their owners. That's already five times higher than the past two years combined.
The debt market is just begging companies to take their money, and most are happy to do so.
What's this all mean for the future? I see two risks. First, by the time this debt starts maturing three to 10 years from now, debt markets will have regained their sanity, and simply won't give junk companies the time of day to refinance, bringing a wave or bankruptcies and restructurings. That's essentially what happened to the financial sector circa 2008. The other, more likely risk is that companies will be able to roll debt over once it matures, but at much higher interest rates than they enjoy today.
As cheap as debt is these days, issuing it is not the no-brainer it might seem. Debt-free companies like Apple (Nasdaq: AAPL) and Google (NYSE: GOOG) might be forgoing cheap capital today, but they're avoiding what could be painful and expensive mistakes down the road, once the bill comes due. Just ask anyone who bought a house in 2005 because of those low, low interest rates.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
