A Tsunami of 'Fallen Angels'
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Today, we kick off our series with an excerpt from the latest issue of Stansberry's Investment Advisory. In this essay – originally published earlier this month – our colleagues Mike DiBiase, Alan Gula, and Bill McGilton highlight a huge danger in the corporate credit markets... and detail one stock that will help protect your portfolio from the inevitable fallout. We hope you enjoy...
A Tsunami of 'Fallen Angels'
Barry Switzer knew exactly where to sunbathe...
A man and his wife were sitting in the bleachers. Switzer laid down behind them, within earshot, just killing time before the next event started on the field.
There, he overheard something he shouldn't have... The sale of "Phoenix" might be announced the following Thursday.
That day in June 1981, he was attending his son's high school track meet on the University of Oklahoma's campus, where Switzer served as the head football coach.
Switzer was no ordinary football coach... He was one of the best. Switzer only lost one game in his first three seasons as head coach. He led the team to national championships in 1974 and 1975. And the team won or shared its conference championship every year from 1973 to 1980.
That day in the bleachers, Switzer might have been daydreaming about winning his next national championship (which he would do in 1985). But he was definitely eavesdropping.
Switzer was not only an elite coach, but he was also an experienced investor. He and his buddies ran several investment partnerships. They often traded on rumors and gossip. Switzer knew the value of the "material, non-public information" he learned about Phoenix.
The man he overheard was George Platt, the chairman of Texas International ("TI"), a small oil and gas business. And by "Phoenix," he was referring to Phoenix Resources, a publicly traded subsidiary of TI.
Switzer already owned TI shares. He correctly surmised that the value of Phoenix's assets was higher than the market value of the stock.
He discussed the tip with his close friends, who all went out and purchased Phoenix's stock.
Phoenix's stock closed at $42 a share on Friday, June 5 (the day before the track meet). On Tuesday, June 9, the stock closed at $47.50 a share. Not only was the stock up 13%, but its trading volume had surged.
Sure enough, on June 10, Phoenix made public its sale and that it had retained an investment banking firm to conduct an evaluation. The stock closed at $61 a share that day. By the end of the week, shares were at $69.25.
However, the surge in trading volume before the sale set off alarm bells. In 1983, the U.S. Securities and Exchange Commission ("SEC") sued Platt, his son Stephen, Switzer, and several others alleging insider trading. The Phoenix trades netted the defendants profits of about $600,000 in less than a week.
It seemed like a clear-cut violation of securities laws.
But the court thought otherwise...
Platt didn't intend to tip off Switzer. Platt didn't personally benefit. Therefore, he didn't violate his fiduciary duty to his company. Amazingly, the court also concluded that Switzer and his buddies did nothing wrong.
If you've heard of Switzer... it's probably for his success coaching at Oklahoma or for the Super Bowl he won in 1996 as the head coach of the NFL's Dallas Cowboys.
We doubt you've heard of TI. Most investors haven't, even though the company was truly special... and its checkered history began before with Switzer's not-quite-insider-trading scandal.
You see, TI was a paragon of financial innovations and risk-taking. And it was "patient zero" for one of the worst credit busts of the 20th century...
In the late 1970s, TI acquired its interest in Phoenix by buying up creditor claims against a bankrupted predecessor company. By opportunistically buying the liabilities of a troubled company, TI was acting as a "vulture investor" – long before the tactic was in vogue.
The way TI raised the capital to buy Phoenix was even more groundbreaking...
TI was tiny. It had only $47 million in revenues in 1976. And after a slew of federal energy regulations, investors were reticent to invest in energy companies like Phoenix.
However, TI raised money with the help of an investment banker named Michael Milken at Drexel Burnham Lambert. With Milken's help, TI issued bonds yielding 11.5% in April 1977. That was far higher than the prime rate of 6.25% – the benchmark rate that commercial banks charged creditworthy borrowers.
It was a watershed event... TI was the first issuer of high-yield – or "junk" – bonds (even though they weren't called "junk" at the time).
That's not to say that these were the first high-yield bonds. Prior to 1977, all newly issued corporate bonds started as "investment grade" ("IG") securities from creditworthy borrowers. But as some of their financial conditions deteriorated, they were downgraded to junk and became "fallen angels."
The bonds of these fallen angels would trade at steep discounts... which drove their yields higher.
Before TI and Milken got together... these fallen angels were effectively shut out of the public credit market. They could no longer publicly issue bonds, and they could only raise money through private placements and bank loans with restrictive covenants.
Milken's stroke of genius was to create a primary market for junk bonds. High-risk companies could then directly issue bonds. Corporate raiders, such as Carl Icahn, also used junk bonds to finance leveraged buyouts.
Junk bonds emerged as a bona fide asset class. And the market has contributed to spectacular credit booms and busts.
Perhaps unsurprisingly, TI – the junk-bond pioneer – went bankrupt.
By 1985, the company had racked up $323 million in long-term debt – in large part due to an unsuccessful exploration program. And it only had $261 million in assets.
From November 1985 to March 1986, the spot price of oil plunged by 67%. The collapse in energy prices – combined with high leverage – caused more than 1,500 oil and gas companies to go bankrupt from 1986 to 1988.
A series of debt-for-equity exchanges prolonged TI's life. But in the end, TI was just one more debt-swollen lamb to the slaughter. TI filed for bankruptcy in 1988 and reorganized as The Phoenix Resource Companies.
TI's demise preceded a wave of defaults. The trailing 12-month junk-bond default rate rose above 10% in 1991.
That's the hallmark of most major debt crises... when the default rate for high-yield bonds vaults past 10%. It happened in 2001. It happened in 2009. And get ready... it's about to happen again.
As we'll show you... the corporate debt markets – the ones for both IG and junk bonds – are dangerously overheated.
We're concerned about credit distress given the leverage in today's corporate-bond market. And we've also begun to worry about a coming tsunami of fallen angels that will hit the high-yield market.
So today, we're going highlight two companies that will soon become fallen angels. We'll also identify another company that already has a junk credit rating and is headed to zero. Its products are obsolete. And it's saddled with debt it has no hope of ever paying off.
We'll use these firms' inevitable downfalls to protect ourselves and insulate our portfolios from the turbulent market...
The Easy-Money Era
Before Michael Milken, nobody could issue high-yield bonds... Today, the junk-bond market is huge.
Last year, U.S. companies issued $284 billion worth of high-yield bonds. And 2013 saw a record $332 billion issuance.
These are large figures. But as we'll show, IG bond issuance dwarfs these amounts... And IG issuance has soared as well.
To a certain extent, these bond issuance totals have been "juiced." Corporate America has gotten a lot of help from the Federal Reserve during this credit expansion. By keeping rates too low for too long, the Fed stimulated immense corporate bond issuance. That has destabilized the market.
The chart below compares the federal funds rate with the rate of inflation. (Here we're using the Fed's go-to inflation indicator, the year-over-year change in the core personal consumption expenditure price index.)
Typically, the Fed lowers the federal funds rate in response to a weak economy. That's what happened from 1989 to 1992 and from 2001 to 2003. Those were emergency responses to recessions. But it only lowered the fed-funds rate down to roughly the core inflation rate during those recessions.
Its response to the financial crisis in 2008 and 2009 was far different...
As you can see in the chart, during our most recent recession, the Fed slashed rates well below the inflation rate, down to nearly zero. And it kept rates there for seven years.
Even after eight rate hikes, the Fed has only raised rates back up to around the inflation rate. But short-term rates are usually higher than inflation.
At the same time, the Fed also stimulated the economy through other "easy money" methods. It bought massive amounts of U.S. government-issued Treasury debt and mortgage-backed securities, expanding its balance sheet to $4.5 trillion. You can think of its bond-buying as "money printing"... effectively flooding the market with liquidity.
Low interest rates encourage leverage. When companies can borrow capital at cheap rates, they don't hesitate. As a result, our economy hasn't deleveraged since the financial crisis.
The numbers on household debt are scary... Americans now owe a combined $1 trillion in revolving debt (mostly on credit cards). And future generations will be burdened by the $1.6 trillion of student loans outstanding.
But the debt bubble that will cause the next economic crisis will be corporate debt.
We've warned about corporate America's continued dependence on debt.
Granted, the financial sector (banks) may be in better shape than it was before the last crisis... But many nonfinancial companies are more highly leveraged than they've ever been.
The Huge Rise in BBB Issues
During the easy-money era, U.S. companies issued $13 trillion worth of bonds.
Companies usually issue bonds to finance investment spending... things like new buildings, plants, and equipment. But when credit is easy to obtain – like it has been in recent years – companies also use debt to finance giant acquisitions... and buy back large portions of their own stock.
Most of the debt issued since the last financial crisis has been IG debt. These are companies considered to be creditworthy and safe.
In 2017, U.S. corporations issued a record $1.4 trillion of IG debt. It wasn't just a record absolute amount, either. It was a record relative to economic activity... IG debt issuance was the equivalent of more than 7% of U.S. gross domestic product (GDP) last year.
The Bloomberg Barclays U.S. Aggregate Bond Index is the "gold standard" for gauging the performance of the corporate bond market. It now represents more than $5 trillion of corporate debt. That's more than double the amount outstanding in June 2009, when the Great Recession ended.
The amount of new debt is concerning. But what most investors don't know is how the credit quality of IG debt has deteriorated. The chart below shows the credit ratings of IG debt outstanding since 1989.
Standard & Poor's (S&P) IG credit ratings range from AAA to BBB-. Anything rated BB+ to CCC- is considered junk.
AAA is the highest tier. It would take an unimaginable calamity – say, a nuclear war – for these companies to not to be able to meet their obligations. S&P rates only two U.S. companies as AAA: Microsoft (MSFT) and Johnson & Johnson (JNJ).
At the other end of the IG spectrum is the BBB tier. Anything below BBB- is noninvestment grade, or "junk" debt.
You can see that the BBB tier has grown the fastest during the easy-money era – nearly tripling in size. BBB-rated debt totals nearly $2.5 trillion today. It's the largest IG credit tier. By comparison, the A-rated tier has "only" doubled. AA is up about 70%. And AAA has slightly shrunk in size.
BBB bonds now make up nearly half of the IG corporate bond universe. That's up from about 30% two decades ago.
The deterioration of the credit quality of IG debt is concerning, because when companies suffer a credit downgrade from BBB it is a significant event...
A Tsunami of Fallen Angels
As we said, when a company is cast out of the IG kingdom and into junk purgatory, it's called a "fallen angel."
A lot of institutional investment managers can't hold high-yield bonds – doing so would violate their investment policies. When a credit-ratings agency downgrades a bond to junk status, it can trigger a cascade of selling.
Even when the selling pressure abates, the pool of high-yield investors is smaller than that of IG investors. About $1.1 trillion of high-yield corporate bonds are outstanding. That compares with nearly $6 trillion of IG debt. So there is less demand for high-yield securities. As a result, high-yield bonds have significantly higher yields.
Since 1997, BBB-rated bonds yielded an average of 0.77%, or 77 "basis points" (bps) more than A-rated bonds. But BB-rated bonds, which are junk, yielded an average of 1.53% (153 bps) more than BBB-rated bonds.
Getting downgraded to junk causes a big jump in a company's cost of debt... much more so than a downgrade from A to BBB. And for companies with growing leverage, that hurts.
Becoming a fallen angel doesn't necessarily mean a company is going bankrupt. According to Moody's (one of S&P's main ratings-agency competitors), only 15% of fallen angels have gone on to default.
You might have expected the last financial crisis caused a deluge of fallen angels. But Moody's data show that only 34 IG credits fell to junk status in 2008, and 37 became fallen angels in 2009. That was barely higher than the average of 29 fallen angels from 2005 to 2007.
We think we'll see a lot more fallen angels in the next two years... and not just because there's more BBB-rated debt.
BBB-rated companies are in much worse shape than they were heading into the last financial crisis.
'Creditworthy' Isn't What It Used to Be
The S&P 500 Index is overrun with BBB-rated companies.
In December 2007, 161 businesses on the S&P 500 carried a BBB rating (32%). Today, there are 233 (47%). In other words, nearly half of the companies in the most important equity index in the U.S. are in the lowest IG tier. If you're an equity investor who thinks that debt problems won't hurt your portfolio, think again.
One of the most important credit metrics is a company's net debt compared with its earnings before interest, taxes, depreciation, and amortization (EBITDA). Net debt is the company's total debt minus its cash. EBITDA is a measure of a company's earnings available to all stakeholders, including the debt holders.
The median net-debt-to-EBITDA (or "net leverage") for BBB-rated companies in the S&P 500 was 1.43 in December 2007. Now, that figure is 2.28. Net leverage is higher for the companies in this credit tier than it was heading into the last credit crisis.
Plus, the median total debt/assets for BBB-rated companies has risen from 27.4% to nearly 33%. We consider anything above 30% to be highly leveraged.
Corporate America is buried under a mountain of BBB-rated debt... nearly $2.5 trillion and growing. And it's less able to handle all that debt than it was heading into the last downturn.
Some of these companies should already be rated junk.
But every bubble needs a needle. And now, we're seeing an ominous credit signal...
Credit spreads are widening.
Corporate bonds are riskier than Treasury debt because some default. To compensate investors for this risk, corporate bonds yield more than Treasurys of similar maturities. That additional yield is known as the "credit spread."
When the spread narrows, it tells us investors are "reaching for yield." They will accept just a small sliver of additional yield to take on the additional risk of holding near-junk bonds. When the spread widens, investors are demanding more return to accept that elevated risk.
In January, BBB-rated bonds yielded just 1.17% (117 bps) more than similar duration U.S. Treasury securities. That was the narrowest spread since mid-2007. (Spreads blew out soon after, foreshadowing the financial crisis.)
We think that will be the tightest of this maturing credit cycle. That's the best it's going to get for the credit markets for quite some time.
Spreads have already widened to 1.91% (191 bps). But we're just getting started...
As you can see in the chart above, BBB spreads have reached 3% (300 bps) twice since 2011...
In late 2011 and early 2012, the credit market was in disarray as the European sovereign debt crisis reached an apex. And the blowout in spreads in early 2016 was associated with energy-sector distress.
Over the next 18 months, we expect BBB-spreads to widen out to 3% (300 bps) once again. But unlike 2016, we think the credit distress will be broadly based.
With rising interest rates and higher bond yields, banks will begin to tighten credit. Many companies will suffer downgrades. And the high-yield market will struggle to absorb all the newly categorized junk bonds.
The credit market will likely force the Fed to pause its rate hikes... but not before stock prices get hammered. And the stock prices of fallen angels will suffer even greater losses.
BBBs to Avoid
It wouldn't be a credit boom without big, levered acquisitions...
This past June, telecommunications giant AT&T (T) completed its acquisition of media leader Time Warner. AT&T paid more than $100 billion in cash and stock.
AT&T financed part of the deal with debt. And when the telecom went to market, investors couldn't get enough of the bonds... So AT&T "upsized" the deal from $15 billion to $22.5 billion.
It was the fourth-largest IG bond deal in history.
Because of the size of the takeover and the additional leverage, S&P downgraded AT&T from BBB+ to BBB.
AT&T now has $175 billion in net debt and is in a precarious position.
We recommend you avoid holding AT&T and the other BBB-rated companies on the list below.
However, we're not recommending you short all of these stocks. For example, AT&T (T) has a dividend yield of 6.3%, so it is costly to short. We think the company may cut its dividend, which would lead a lot of income investors to bail out. But we're not willing to pay more than 6% per year to stay short until that happens.
But the list includes a BBB-rated company we think is a more attractive short candidate:
Credit Casualty No. 1
Discovery Communications faced a problem...
The company's major TV channels were all losing subscribers. From 2015 to 2017, the Discovery Channel's audience shrunk by 5.4%. TLC and Animal Planet faced similar declines.
Cable "unbundling" was taking its toll. (We talked about Discovery as an unbundling victim in our December 2017 issue.)
Discovery's solution was a big acquisition... of more TV channels facing the same problem.
In mid-2017, Discovery agreed to buy Scripps Networks. Scripps' channels include HGTV, Food Network, and the Travel Channel.
The acquisition closed in March 2018. The combined company is now known as Discovery (Nasdaq: DISCA).
It was a cash-and-stock transaction with a total value of around $14.6 billion, including Discovery's assumption of Scripps' net debt of $2.7 billion. And in September 2017, Discovery priced a six-part, $6.8 billion bond offering to help fund the acquisition.
Discovery now has about $17 billion of net debt. Take a look...
S&P has rated Discovery at BBB- since November 2015. And following the Scripps merger announcement, S&P revised its outlook on Discovery from "stable" to "negative." That means it's one tiny step away from junk status.
The company's net debt/EBITDA ratio will be around 4 this year.
Discovery has halted its stock buybacks. And it will use available free cash flow ("FCF") to cut its debt. (FCF is the cash left over after all operating expenses and business investments are paid.)
Discovery thinks it can reduce net leverage to 3.5 by the end of 2019. If it can't, it's likely to be downgraded to junk.
We doubt Discovery will escape that fate. The decrease in net leverage not only hinges upon cutting its debt, but also an increase in EBITDA.
Discovery's management thinks it can achieve "synergies" of $300 million to $350 million. We're skeptical. Most mergers fail to deliver the expected cost savings.
Plus, Discovery will continue to be plagued by cable unbundling.
Discovery responded by incorporating its channels into "skinny bundles." But skinny bundles are far less lucrative for channels than the traditional cable TV bundles.
Discovery partnered with video-streaming service Hulu this past September. And video-streamer Sling TV is adding nine Discovery channels to its lineup. The annual fees from these two deals should total less than $50 million. That's not even 0.5% of Discovery's total estimated revenues of about $10.8 billion this year.
Advertising revenues will continue to be under pressure as well. Discovery's content is mostly unscripted reality TV and nature shows. This "real-life entertainment" is cheaper to produce than scripted shows, but it's also easier for competitors to duplicate.
Earlier this week, Discovery CEO David Zaslav said that advertising revenue would come in below the 3%-5% increase that management previously forecast. Expect more disappointments like this as advertisers shift spending away from TV to online media.
We believe Discovery won't be able to cut its debt nearly as fast as it expects. And that means it's at serious risk of a downgrade to junk status... which will crush the stock.
Sell short shares of Discovery (Nasdaq: DISCA) when it trades for more than $26 a share. Use a 25% trailing stop.
We recommend you keep your position size small. Short selling during a bull market can be challenging, especially during periods of intense volatility like we've seen lately.
Good investing,
Mike DiBiase, Alan Gula, and Bill McGilton
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