Be Warned... The 'Debt Dams' Are Breaking

China is underwater… The world's largest dam could soon collapse... Thanks to COVID-19, corporate debt levels are dangerously high... The early warning signs are all around us... Be warned – the 'debt dams' are breaking...

It doesn't seem possible that 2020 could get any worse...

In addition to a global pandemic that has upended our daily lives, leaving millions of folks without jobs, we've seen rioters destroy parts of several U.S. cities... Australian megafires... swarms of locusts in Africa and the Middle East... "murder hornets"... and more.

But with all that's going on, I (Mike DiBiase) bet you haven't heard about a looming disaster in China. The world's most populated country is enduring its worst flooding in decades...

It hasn't been this bad since 1998, when government estimates showed that floodwaters impacted around one-fifth of the country's population of more than 1 billion. Back then, more than 3,000 people died and the economic damage totaled more than $20 billion.

This summer, China has been deluged with a prolonged period of heavy rain. The China Meteorological Administration issued heavy rain warnings for more than 30 straight days.

According to the Wall Street Journal a couple of weeks ago, the floods already had caused more than $16.5 billion in damage this year. And there's no end in sight for the rain...

As a result, the world's largest dam is now in danger of collapsing...

The Three Gorges Dam in central China sits on the Yangtze River. Stretching 3,900 miles, the Yangtze is the third-longest river in the world and China's most important waterway.

The dam is five times bigger than the Hoover Dam in Nevada, spanning 7,700 feet with a height of more than 600 feet. It's also the world's largest hydroelectric power plant.

The reservoir behind the dam holds 42 billion tons of water... When the dam is full, it's so much water that its concentrated weight slows the Earth's rotation by 0.06 microseconds.

Although the idea of a dam at the Three Gorges site was first proposed about a century ago, construction didn't start until 1994. The dam was completed in 2006. At the time, China's state-run media outlets boasted that it could withstand the worst flood in 10,000 years.

Now, just 14 years later, it's in jeopardy of being washed away...

The heavy rain has caused the Yangtze River to swell, with water rising six feet above the Three Gorges Dam's warning level in July. The enormous weight of the water behind the dam has already caused landslides along the reservoir.

Experts outside of China have closely tracked the situation... Satellite images even before the recent weeks of continuous rain seemed to show that the dam had bent slightly.

The Chinese government downplayed the situation at first, saying the issue was with the satellite images, not the dam. But now, officials have started to acknowledge a problem...

A few weeks ago, the Chinese government finally admitted that the dam had "deformed slightly" from the flooding in July. Operators maintain that the dam is still safe despite the defects. But the danger is not over... Two to three typhoons are forecast to hit in August.

It would be truly devastating if the Three Gorges Dam were to collapse...

Tens of millions of people live downstream from the dam along the Yangtze River, including the large populations in Wuhan and Shanghai. (That's right, the same Wuhan that's believed to be where the global COVID-19 pandemic began.) If the dam fails, hundreds of thousands of people will likely die... and millions more will probably see their homes washed away.

Critics of the Three Gorges Dam believe concrete and steel bar welding used to build the dam were substandard. China's state-run media no longer believes the dam could survive the worst flood in 10,000 years. It revised the claim all the way down to 100 years... a major loss of confidence in the dam's strength.

The truth is... I'm not a structural engineer. I can't tell you whether or not the Three Gorges Dam will ever collapse... or whether it's within years, weeks, or even days of a catastrophe. I certainly hope not... No one wants to see millions of people lose their homes or worse.

But as regular Digest readers know, I am an analyst who tracks what's going on with the credit markets. And as I read about the dangerous floodwaters rising at the Three Gorges Dam, it reminded me of how the COVID-19 pandemic is exacerbating our debt problem...

The COVID-19 pandemic is a lot like the storms in China, dumping endless rain on the global economy...

Government and corporate debt levels are rising steadily, day after day... much like the waters along the Yangtze River. With most businesses' sales down significantly due to the shutdowns, they're forced to borrow just to pay the bills.

The longer COVID-19 keeps the world's economies shuttered – or at least slowed – the higher the debt "floodwaters." Like the floodwaters at the Three Gorges Dam, this rising debt is putting massive pressure on company's capital structures.

Not every company will be able to withstand the pressure. Many "debt dams" will break.

You can think of a 'debt dam' as a divider between a company's debt and equity...

The debt dam separates a company's debtholders from its stockholders.

Think of the company's stockholders as the folks who live just down the river from the dam. The company's debtholders live above the dam, near the reservoir. The flow of water in the river is the capital that the company needs to flourish.

The debt dam brings a lot of benefits...

First, it keeps the stockholders from flooding by giving the large amounts of capital a safe place to accumulate. In other words, when companies want to raise cash, they can use their reservoir of debt. By using debt to raise the capital, stockholders aren't flooded with new shares of stock every time the company needs cash.

Second, the dam generates power for stockholders. In that regard, you can think of debt like a power generator for corporate earnings. It allows companies to produce much higher profits on a given amount of equity investment.

Let's look at an example to show you what I mean...

Assume a company needs $100 million in new capital. It will use the cash to invest in a business that will earn $20 million per year in operating profits.

The company has a choice... It can raise the capital by issuing new equity (stock), by issuing new debt (using the reservoir), or some combination of the two options.

First, if the company raises the $100 million by issuing 10 million shares of stock at $10 per share, it will earn after-tax profits of $16 million (assuming a 20% tax rate). Its earnings per share will be $1.60 ($16 million in profits divided by 10 million shares). That's a 16% return on equity ($16 million divided by $100 million in equity).

Now, instead, assume the company raises half of the $100 million by issuing debt at a 6% interest rate. Instead of 10 million new shares outstanding, the company only has 5 million. Because it now must pay interest on the debt, its after-tax profits will be 13% lower.

But here's where the power of leverage comes in...

While the company's $14 million in after-tax profits are lower when using debt, its earnings per share will be 75% higher, at $2.80 per share ($14 million in profits divided by 5 million shares). And the return on equity jumps to 28% ($14 million profits divided by $50 million in equity), which is also 75% higher.

Because the company has less equity outstanding, its earnings per share and its return on equity are much higher. That's a tremendous difference. In other words, by issuing debt instead of shares, the company can supercharge its return on equity and earnings per share...

The following table shows the differences between the company's profits, earnings per share, and return on equity ratios under the two different scenarios. Take a look...

The more leverage (debt) used, the higher the returns. That's why the management teams at most corporations love debt so much. It's a way to amplify their profits and returns.

The problem, of course – as with most things in life – is excess...

Too much of a good thing becomes dangerous... The extra leverage brings added risk. When the sun stops shining, the debt doesn't go away. It still must be repaid.

That's exactly the problem facing many companies today. They were already levered to the hilt even before the COVID-19 pandemic began... U.S. corporate debt was at an all-time high, both in nominal dollars and as a percentage of gross domestic product.

And now with the economic downturn caused by the COVID-19 pandemic and related shutdowns, corporate debt piles are growing dangerously larger.

Like the Chinese government officials operating the Three Gorges Dam amid prolonged periods of heavy rain, companies hope the COVID-19 "storm" passes quickly. But immense pressure is building. Their "debt dams" are fast approaching the point of failure...

And the thing is, many will collapse.

When a 'debt dam' breaks, it completely wipes out all equity...

When a company goes bankrupt, the equity instantly becomes worthless. The debtholders take over everything. Millennial day traders haven't learned this lesson yet.

Companies may emerge from bankruptcy at some point down the road, but they only do so with new owners.

Unfortunately, the economic storm isn't likely to subside. The spread of COVID-19 isn't slowing down... We've eclipsed 20 million reported cases globally, including 5.2 million in the U.S. And we simply don't know what will happen in colder weather this fall and winter.

The longer we're dealing with the threat of COVID-19, the more "debt dams" that are in danger of collapsing. That's why I believe a vast wave of bankruptcies is approaching...

In fact, we're already starting to see this play out across corporate America...

According to credit-ratings agency Standard & Poor's ("S&P"), 82 U.S. companies defaulted on their debt so far this year... including 61 in the second quarter. That's the highest number of quarterly defaults since 80 companies defaulted in the second quarter of 2009.

The list of companies filing for bankruptcy so far in 2020 includes 112-year old gas-engine maker Briggs & Stratton... acrobatic-show company Cirque du Soleil... gym operator 24 Hour Fitness... restaurant chain California Pizza Kitchen... vitamin and supplement retailer GNC (GNC)... Ascena Retail, owner of women's apparel stores Ann Taylor, Loft, and Lane Bryant... and most recently, Lord & Taylor, the country's oldest department store.

And unfortunately, this is just the beginning. Things will get much worse...

We can see what's coming by looking at the number of companies whose credit has been downgraded. Downgrades are an early warning sign... They always come before defaults.

So far this year, S&P has downgraded the credit of more than 1,970 companies, including 1,100 in the second quarter. That's already more than any year on record. Take a look...

It only takes one small part of a dam to fail for the entire structure to collapse. The same thing can be said about the credit markets. It's only a matter of time before the credit market collapses.

Another reason I'm worried about the credit markets today is the 'weakest links'...

"Weakest links" are companies with already poor credit ratings ("B-" or lower) that are on negative credit watches or with negative credit outlooks from S&P.

As you can see in the following chart, the number of weakest links globally is now at an all-time high of 611. It's more than double the peak during the 2008-2009 financial crisis...

Here's why that's important... The default rate for the weakest-link companies is around eight times higher than the overall default rate.

In other words, we can expect the default rate among weakest links to soar soon... and the overall default rate to follow. When the default rate soars, investors panic.

Finally, we have one more reason to expect a vast wave of bankruptcies...

You see, banks across the country are once again tightening credit. That means they're making it more difficult for companies to borrow money.

In the latest Federal Reserve survey on the lending standards of large and small banks across the U.S., more than 70% of banks said they're tightening credit. That's the highest percentage since October 2008.

And tighter credit conditions often precede a soaring default rate. Take a look...

This is important...

Many companies that rely on banks to simply "roll over" their debt when it comes due will have nowhere to turn when banks are tightening. These borrowers depend on new loans to pay off their existing debt as it comes due. Without access to new credit, they'll simply die.

A trend of tightening credit will hasten the wave of bankruptcies.

I believe we're still in the early phases of a slow-motion disaster...

We're just seeing the initial cracks in the side of the dam today. The real damage hasn't even been done yet. The numbers are about to get much, much bigger...

The U.S. high-yield default rate is about 5% today. That means only 5% of all corporate borrowers have defaulted over the past year. That's only slightly higher than its long-term average of 3% to 4%.

But S&P is now forecasting that the high-yield default rate will rise to 12.5% by next March. That would be the highest default rate since the Great Depression in 1932.

S&P's current "pessimistic" forecast projects the default rate to reach 15.5%, up from 13% just a few months ago. So as you can see, the storms will likely get much worse.

And yet, investors don't seem worried at all about what's happening...

After plunging more than 30% in about a month earlier this year, the benchmark S&P 500 Index is once again flirting with a new all-time high. The tech-heavy Nasdaq Composite Index has been making fresh all-time highs since June. And as my colleague Chris Igou noted in yesterday's Digest, you can find reasons to be bullish on stocks in the short term.

Debt investors don't seem to be concerned with the approaching storm clouds, either...

The high-yield credit spread – the difference between the average yield of so-called "junk" bonds and the yield of similar-duration U.S. Treasury notes – tells us how much risk that investors are pricing in bonds at any given time. When the spread is low, investors aren't concerned at all about defaults. When it's high, they're worried about getting paid back.

The spread has fallen to around 500 basis points ("bps") today. It's once again below its long-term average of around 600 bps, after rising to more than 1,000 bps in late March... a few weeks after the World Health Organization declared COVID-19 a global pandemic.

The lack of worry among investors is concerning...

The Federal Reserve won't bail out every company. Its efforts to help most businesses so far were only done to instill confidence in the credit markets. The Fed has prevented credit from drying up. But in reality, it's just extending the day of reckoning for many companies.

The excessive debt balances can only continue to rise for so long. Eventually – and in most cases, suddenly – companies collapse. Unsuspecting investors will be wiped out.

I've shown you the warning signs of record levels of corporate downgrades... all-time highs in the number of weakest links... and a rising number of banks tightening credit.

It's only a matter of time before many more debt dams break. Consider yourself warned.

And if you're interested in keeping up with the latest twists and turns in the credit markets...

I encourage you to consider a subscription to our distressed-debt newsletter, Stansberry's Credit Opportunities. Not only do my colleague Bill McGilton and I provide monthly updates on what's happening in the credit markets, but we also show you the best ways to profit.

In fact, we're working on this month's issue as we speak...

We plan to recommend a bond issued by a company that's almost certain to go bankrupt. But the thing is, it won't happen until long after we've been paid in full on our bond. We stand to make an annualized return of roughly 25% by capitalizing on this situation.

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The ideal time to invest in bonds is when a crisis strikes. When that happens – which will likely be in the months ahead – we plan to help our Stansberry's Credit Opportunities subscribers make a killing. That's because you can earn stock-like returns with bonds while taking on far less risk than owning stocks.

But if you're like most folks who are new to bonds, you're probably still skeptical. You might think there's some type of "catch"... that investing in bonds can't really be easy and safe.

That's OK... you don't have to take my word on it. One of our longtime subscribers shared his own experiences in using our corporate-bond research. I guarantee you don't want to miss what he had to say... As you'll see, it could change your life forever. Learn more here.

New 52-week highs (as of 8/12/20): Dollar General (DG), Home Depot (HD), Innovative Industrial Properties (IIPR), iShares U.S. Home Construction Fund (ITB), Maxar Technologies (MAXR), Procter & Gamble (PG), Trulieve Cannabis (TCNNF), and Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIP).

In today's mailbag, more feedback on Porter's prediction about Kamala Harris... the 2020 presidential election... and a note of thanks for a couple of past recommendations. Remember, we can't provide individual investment advice, but we always welcome your questions and comments at feedback@stansberryresearch.com.

"Well [Porter], your prediction is almost here. [Kamala Harris] is the VP choice now. But I would not be surprised if something happened and Biden dropped out for health reasons and she was elevated to the nominee." – Paid-up subscriber Jeff S.

"Jeff Gundlach correctly predicted 2016 – he says Trump wins again in 2020, and I agree!" – Stansberry Alliance member Shawn S.

"Years ago I bought some Altria stock after you recommended it. It has performed very well for me – THANK YOU! More recently, I bought some Travelers stock which you also recommended at around $95/share. Again THANK YOU! After the next crash I will buy some more. I'm always looking for your forever stocks to go on sale. My portfolio has benefited from your advice." – Paid-up subscriber Jack S.

Regards,

Mike DiBiase
Atlanta, Georgia
August 13, 2020