Credit Spreads: The Coming Resurrection Of Polly

There is an old Monty Python skit about a parrot whose lack of movement and refusal to respond to prodding leads to an intense debate over what state it is in. Is it just sleeping, as the proprietor of the shop that sold it insists? A very tired parrot taking a really deep rest?

Or is it actually dead, as the customer who bought it asserts, offering the fact that it was nailed to its perch as prima facie evidence that what they are looking at is indeed, a late parrot, as deceased and expired as it can possibly be. We hereby submit that Polly, the “Norwegian Blue”, serves as a perfect stand-in for the risk perceptions of today’s corporate (and EM) bond buyers.

Polly, we hereby rename thee “The Suspicion of Creditors”.

Now, if Polly has in fact breathed her last,then we would have to assume she will be miraculously resurrected one of these days. Maybe she will come back as a slavering zombie, which would actually be quite fitting. If Polly is in a coma, she is bound to suddenly wake up one day, and we mean “suddenly” (as explained further below). One thing is certain though: just like the Terminator, Polly will be back.

Diverging Signals in a Giant Credit Bubble

Although listed companies have amassed a lot of cash in the aggregate, Moody’s recently pointed out that the ratio of debt to cash has increased to levels that would normally indicate far higher expected corporate default rates and much wider credit spreads than are currently in evidence.

To this one must keep in mind that just a small handful of listed US companies actually hold the vast bulk of said cash. As of mid 2016, just five US tech companies held more than one third of all corporate cash (AAPL, GOOGL, MSFT, CSCO, ORCL) – a share that has grown even further over the past year as far as we can tell. Apple alone has reportedly more cash on its balance sheet than eight entire industrial sectors.

Note here that there is some disagreement over what should be counted as “cash”, but generally it is thought of as “cash and cash equivalents”, which include highly liquid short term investments such as US treasury bills and similar securities. In light of their liquidity and the existence of a well-developed repo market, one could well term these secondary media of exchange.

A long term chart by Moody’s depicting the non-financial corporate debt to internal funds ratio vs. actual and expected corporate default rates. Even ignoring the fact that the aggregate debt-to-internal funds ratio is actually a bit misleading in a sense, due to the concentration of cash holdings at just a few companies (most of which have very little debt to boot), the recent divergence in default expectations from the ratio is highly unusual. It is a good bet that this dichotomy will eventually be resolved by a rapid adjustment in expectations, since the underlying perceptions result to a great extent from self-reflexivity. In other words, the “predicted” portion of future default rates is eventually going to veer back up, because the “self-fulfilling prophecy” function embedded in this forecast will one day simply make a 180 degree turn (and people will long thereafter discuss the reasons for this surprising development no-one could see coming).

Moreover, technology companies tend not to be overly indebted, which means that the idea that the vast corporate debtberg is somehow offset by corporate cash holdings is extremely flawed (note also that according to the Fed’s most recent flow of funds data, total corporate liabilities are approximately 10.7 times larger than cash holdings, so depending on definitions, leverage is actually already a tad greater than depicted in the chart above).

A plethora of data points suggests that we are currently experiencing one of the most manic credit bubbles in history. Below are several charts illustrating the situation. Note that these are just a few miscellaneous credit market-related data we have come across in recent weeks, the point is that they all send the same one-sided and clear message: Polly is comatose.

Left: issuance of leveraged loans (ytd. through September of each year); Right: median IG gross leverage. Both have recently hit new record highs – click to enlarge.

Left: percentage of “cov-lite” loan issuance reaches a fresh record high. Compare this to 2008-2010, when suspicion was wide awake. Loan covenants contained a variety of conditions that are attached to loans or debt securities in order to protect creditors, which “cov-lite” loans obviously lack (as an example, such conditions may include a commitment by the borrower to maintain a certain minimum net debt/EBITDA ratio, or limit dividend payments to a certain percentage of net earnings, etc., etc.). The surge in cov-lite issuance indicates that lenders no longer feel the need to discriminate, just as long as they can grab a little bit of yield.