Debt: the new normal. Is it ok? If not, what can be done about it?

 

“Neither a borrower nor a lender be; For loan oft loses both itself and friend.” 

That famous line by Polonius in Shakespeare's Hamlet would seem prudent advice in most ages. However in today's world, we find our economy awash with debt as never before. The reasons for this are numerous. 

One could argue that it starts with perhaps perverse tax incentives, whereby companies are essentially encouraged to borrow by being able to offset interest costs against their profits. The original rationale for this was the belief that borrowing would only occur in order for the company to grow. This therefore makes sense: a tax regime that encourages growth is of course a good thing. 

But when investor demand for debt is such that a major cash-rich firm borrows to fund a dividend payment, as Apple has repeatedly done (Apple), then many would argue that something has gone very wrong with the system.

Then of course there is the ongoing fall out from the GFC. For twelve years now, central banks have been throwing trillions of dollars into the financial system in an attempt to reinvigorate (or in the ECB's case continually rescue) the economies which they oversee. 

Quantitative Easing was meant to shore up the banking system temporarily after the initial crash. The fear at the time was that it would simply cause runaway inflation. Yet more than a decade later it is still with us (even before the COVID crisis) and, coupled with negative interest rates, many banks are still in a very precarious position - particularly in continental Europe.

Investors "hunt for yield" means that there are thousands of "zombie" companies, who would otherwise have fallen into bankruptcy but are being kept alive by being able to find endless sources of debt finance. 

The situation is even more advantageous if you actually run a successful firm. When LVMH looked to buy Tiffany's, earlier this year, they were able to raise the billions of Euros required at a negative yield! So they were being paid to borrow (LVMH Tiffany's). Try explaining that to someone in the 1980's (not that long ago) when borrows were paying credit card rates of interest on their mortgages and business loans.

Now with the COVID crisis, central banks are feeling compelled to pump trillions more into the financial system, to keep it afloat.

For an investor this leads to a curious state of affairs. The risk/reward calculation on which investing is normally based, has become redundant. A company's economic fundamentals no longer imply the same risk that investing in bonds (or indeed equities) that it used to.

Similarly though, there is little upside either. The wall of money means that meaningful yield is increasingly hard to find. Indeed as the LVMH example shows, often bond investors are now comfortable making an investment that should lose them money over time.

Today rating agencies may seem somewhat irrelevant. While they were very much central to the makings of the GFC, their role is still an important one now. Or at least it should be. The swathes of zombie firms shows that investors are so far seemingly happy with low grade debt, as long as it provides them with a positive yield. The risk to capital is a much lower concern nowadays. 

Some are predicting that a rude awakening is not far away, however. Indeed it is something that I have speculated for several years now. The size of the bond market that is just above junk (or in typically brilliant beguiling financial terminology: high yield) has never been so large. As this article in Morning Star explains (Morningstar) should the agencies lose patience and actually start to downgrade a few of the more major zombies, then the results for investors could be grim indeed.

It seems hard to argue that the a situation where the normal risk/reward rules are so skewed is attractive, or even acceptable. For economies to flourish and wealth to increase, there must be "creative destruction". There must be winners and losers. Capital must be focused on viable businesses and those that are not viable must be allowed to fail.

So what might be changed?

At the most basic yet fundamental level, I would argue that the incentive for companies to utilise debt financing must be brought under control. Perhaps by limiting the time during which the interest may be offset against profits, to the first five years of the firm's life. As with any tax change, clever accountants will probably find some way around this but that does not me the authorities shouldn't try.

The rating agencies, Standard & Poors, Moodys, Fitch must be moved closer to the regulator's orbit and away from a profit-driven model. Their role is too important for them to be faced with the conflict of interest that helped create the GFC. They should represent the interests of the investor alone, not the interests of the issuer. A tightening of their criteria for investment-grade certification, may be long overdue.

Most challengingly, I believe that central bankers must find a way to restore the old order of risk and reward to investing while preventing a banking collapse. They might start by desisting with negative interest rates, whose main primary effect so far appears to have been a further weakening of banks' balance sheets. 

None of this is easy, and there will doubtless be multiple unintended consequences and mistakes along the way. However it does not appear that continuing as we are is in the interests of anyone save for businesses of dubious quality and some very wealthy investors in the equity markets.

Dunotter disclosures

 Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.