Rupal Bhansali, who runs global and international funds at Ariel Investments, thinks many investors are focused on the wrong problems. For several years, the market was worried about General Electric’s earnings, but “the big correction in its stock price has come about because of balance sheet risk,” Bhansali says. From General Electric’s underfunded pension, to the debt the company has assumed in order to maintain a lofty dividend, to the black hole created by the company’s insurance liabilities—the future of GE, an American icon, is now in question.
Triple-B-rated debt is in an extended twilight zone of its own, in Bhansali’s view, and she thinks many companies will experience difficulty. “We’ll start calling high yield ‘junk’ all over again,” she predicts.
How serious is the problem? “[Fed chairman] Powell said it doesn’t seem systemic,” noted PGIM Fixed Income senior portfolio manager Mike Collins. “It probably isn’t. But if enough issuers run into trouble, risk could be repriced.”
Therein lies the rub. Even if the problems are isolated and Wall Street banks and other financial institutions possess sound balance sheets, memories of 2008 linger. If companies get in a jam, Almeida questions whether these sources of credit will provide liquidity to the extent they once did.
How did major parts of corporate America get here? Between 2009 and 2012, many companies deleveraged and whipped their balance sheets into impressive shape.
By 2014, capital allocation had emerged as an issue of paramount importance in the boardroom. Most businesses had wrung all the value they could out of cost-cutting while sales had recovered nicely from their post-recession trough. So companies used their free cash flow for financial engineering activities like stock repurchases and dividend increases.
For growth companies in Silicon Valley, dividends and buybacks are sometimes seen as an act of surrender and an admission that a business has exhausted its imagination. For mature companies, shrinking the share float and lifting payouts may make sense. The problem arises when they borrow money for non-core purposes, as many have.
Ten years ago, triple-B debt represented 32% of all investment-grade debt; today it stands at 50%. That’s an increase from $715 billion to nearly $3.2 trillion, says Steven Romick, manager to the FPA Crescent Fund.
“Corporate debt has continued to deteriorate,” he says. “Certain overleveraged companies will have a tough time making it through the cycle.” Not surprisingly, Romick is avoiding high-yield bonds.
Reallocate To Value, International?