In October 1989, a 7.1-magnitude earthquake now known as “the little big one” shook northern California just as Oakland and San Francisco were starting Game 3 of the World Series. The double-decker Nimitz Freeway in Oakland buckled and collapsed, killing 41 of the 63 people who died in the quake.
In the following weeks, the New York Times investigated the questions on many people’s minds — did California officials know the freeway wouldn’t survive a strong earthquake? Should they have known or at least suspected it? If its integrity was suspect, why were actions not taken to strengthen or close it down? The investigation exposed both structural deficiencies and political delays that contributed to what may have been a preventable disaster.
While it was impossible to know ahead of time exactly how each structure and roadway would respond to a major earthquake, state officials had been warned about the general risks and failed to take proper precautions. Similarly, we’ve heard rumblings several times in the last decade that interest rates were on the cusp of rising from their near-zero recessionary levels, but it’s actually starting to happen now. In February, Google searches for “rising interest rates” hit the highest level since 2004. The borrowing, lending, investing public senses change is afoot.
Interest rates are, at their simplest, the price of money, so the potential ripple effects from rising rates will reach across the financial markets. But let’s focus on the epicenter — fixed income. It’s common knowledge that bond prices move inversely with interest rates, but factors like maturity date, issuer leverage, or industry exposure all influence how exposed a particular bond, company or sector is to interest rates. So which parts of the market are most vulnerable today, and what can you do to shore up your clients’ portfolios?
For starters, net leverage for the median S&P 500 company is at 1.6x, the highest level in more than 40 years, fueled by the low cost of issuing and carrying debt over the last decade. The headline leverage number is well off its historic highs, but the weighted average is skewed lower by the high concentration of cash among a few of the biggest and highest-quality borrowers in the index (think Amazon, Microsoft, Apple, Google, and Berkshire Hathaway). BBB issues also make up a growing share of the investment-grade mix as large caps have levered up to fund buyback programs and M&A.
While investment-grade companies have partaken in the cheap debt buffet and will feel some financial indigestion from rising rates, they aren’t likely to become distressed even if we were to see simultaneously higher rates and deteriorating economic conditions.
The same can’t be said of high-yield issuers, however, most of which are small-cap companies. From both an interest rate risk and a credit risk perspective, the US high-yield corporate debt market looks as risky as it has in years. These metrics should act as red flags for investors:
1. Historically high small-cap leverage.
One of the prevailing narratives in the last few years is that U.S. companies have been stockpiling large amounts of cash, thereby reducing their liquidity risk. While factually accurate, this misses the fact that corporate debt has been growing much faster than corporate cash. Russell 2000 net leverage, which compares debt in excess of a company’s cash on hand to its EBITDA, is now 4.5x, as shown below juxtaposed against weighted average total debt. That’s the highest level in the last 25 years, with the exception of early 2016, when small-cap profits dropped suddenly, temporarily inflating the ratio to over 6x Even more alarmingly, 14.6% of the S&P 1500 don’t generate enough operating income to cover their interest expense as of the fourth quarter of 2017, up from 12.2% a year earlier and 5.7% 10 years earlier at the start of the Great Recession, according to Bianco Research.
Different business models and industries can carry varying debt loads, but I would venture to say that for the typical small-cap company, 4.5 times EBITDA is an unsustainable amount of leverage and could pose a threat to its financial stability when the business cycle inevitably turns downward.
Consider also the limitation on business interest deductibility in last year’s tax reform. Net interest expense above 30% of adjusted taxable income (ATI) is no longer deductible for most businesses with more than $25 million in revenue. ATI, as defined in the legislation, is roughly equivalent to EBITDA from 2018-2021, but it will automatically change in 2021 to include depreciation, amortization and depletion, making it closer to EBIT. In most cases, this will mean companies hit the 30% cap sooner and won’t receive a tax benefit from any additional interest expense.
According to FactSet, Russell 2000 companies are already spending a third of their EBIT on interest. So while there is a little breathing room under the short-term ATI definition, once it resets lower small caps will already be maxing out their interest deductions even if debt and interest rates stay at today’s levels. As Moody’s recently put it, tax reform will likely be a net negative for highly leveraged small caps. “Loss of interest deductibility will result in lower cash generation, especially among companies rated single-B and lower, weakening their ability to service high interest costs and so also shrinking their refinancing opportunities.”
2. High mix of floating-rate debt.
According to Goldman Sachs research, 42% of debt held by Russell 2000 companies is floating rate, compared to only 9% for the S&P. While companies with only fixed-rate debt won’t feel the pressure of rising interest rates on their bottom line until they refinance, floating-rate borrowers will see an immediate drop in earnings and cash flows. Libor (3-mo. USD), the most popular reference rate for such loans, has been accelerating and at the end of February broke through 2%, a level not seen since 2008. For companies that don’t fully hedge their rate exposure, interest expense could start ticking up noticeably in Q1 earnings.
In the next installment, I’ll cover three more warning signs that a seismic bond shift is coming.
Mark is a co-founder of Intrepid Capital. He is also the lead portfolio manager of the Intrepid Capital Fund, the Intrepid Disciplined Value Fund, the separately managed Intrepid Balanced and Intrepid Disciplined Value portfolios and the Intrepid Capital, L.P. He has over 30 years of experience in asset management. Mark received his B.A. in economics from the University of Georgia. Travis serves on the Board of Trustees of The Bolles School and the Board of Directors of Jacksonville Clay Target Sports. He is also a member of the Ponte Vedra Rotary Club and YPO-WPO.