The inevitable fate of corporate bonds; the day comes to show it are emptied bags

Corporate bonds are bought by investors for the purpose to supplement their income. Bonds are an important category of the fixed income market. This is a good  time to take a look at why companies are borrowing money by selling bonds. The graph below shows in the first quarter of 2020 there’s an execrated phase of corporate borrowing. In this blog we try to figure out why this is happening. 

The official story says that this is caused by Corona. A better perspective is that Corona may be the actual pin that pricked the corporate debt bubble that has been building since the Fed became aggressive in its market interventions since the 70’s by transforming the US dollar from a gold backed currency into a pure fiat money scheme. As a result of the following boom – burst cycles, the Fed and other Western central banks started to interfere in the interest rates markets to make lending money ultra cheap trying to prevent booms going bust. The consequence was that this invited companies to financial engineer their balance sheets by borrowing money to finance share buybacks by taking shares out of the stock market to push up the prices of the remaining outstanding shares.

Let’s take a closer look at what is happening at company level. If you invest your money, you want to know what you are exactly buying, right? When you go to a car dealer to buy a car, you not only want to examine the outside of the car, you also want to look what’s under the hood and making a test drive to check if everything works well. When you want to lend your money to companies it’s the same story. You are not only interested in what goods or services the company sells, you want to examine what’s under the hood, by taking a closer look at the company’s balance sheet, to get insight how healthy the company is. 

Income, expenses, assets and liabilities are part of a balance sheet. It tells you a lot about how well a companies is doing. A healthy company has fresh, new money coming in, and if it is managed well, there comes more money in than goes out. In this situation it has a surplus, aka assets (savings). Such companies may borrow money because they can afford it as they’re in a position that they need to do a sizable investment to grow the business, increasing their production, that grows cash flow and accumulate more assets as end result. 

Nowadays, after 50 years of inflationary policies and interest rates interventions by Central Banks, the number of such companies are less. There wasn’t a corporate debt bubble in the early 80’s when interest rates were high, as thus borrowing money was a costly activity.  

Today less companies are in a sustainable healthy condition. What is the impact of central banks policies on companies balance sheets?  Put differently: how has the multiple decade long easy money polices transformed companies balance sheets? The figure below illustrates the transformation aka deterioration of balance sheets.

As result of financial engineering and weakness in the real economy, companies are generating less income.  Less new money comes in. Decrease of incoming money has been compensated by increasing borrowing via corporate bonds.  

Companies started to liquidate savings (assets) and have built up debt (liabilities) on their balance sheets. Nowadays there are lots of so called ‘zombie companies’ that have little to no income, no savings and live on corporate debt. Such companies are far from profitable, don’t have any real growth in terms of positive cash flow. Central banks policies made companies fragile, their balances sheets deteriorated.  When zombified companies are hit by Corona lock downs, it impacted the corporate bond market shown in the chart below.  

A record of $150BN investment grade bonds (IG) were downgraded to junk (HG). The so called fallen angels have sparkled concerns about what will happen to the $1.3 trillion junk bond market as hundreds of billions of formerly investment grade debt downgrades to junk (HG) and reprices the yield curve. How can already indebted companies pay back even more leveraged debt at higher interest rates in a weakening economy that may turn into a depression? Why have companies borrowed even more now you think? Because they have to survive. Is that a healthy sign? Hell no! The Fed has jumped into the junk bond market, again trying to prevent imploding of the bond bubble. The consequence of the fed interference is that the bond market is even more distorted and disconnected from economic realty.

Let’’s get back where we started, the corporate bonds are bought by investors to supplement their income and secure their savings. Would you lend money to heavy indebted companies that live on debt to survive instead use it to grow their business and cash flow? These bonds are empty bags, they are sold promises of steady returns on corporate investments. But lots of corporate investments are financial engineering schemes driven by self interest to stay alive and keep share holders happy.

I think being a being bond holder, you put yourself at huge risk. Time will come showing the real risks of corporate bonds, namely the hidden counter party risks by lending to overly indebted companies that had to borrow because they have no money coming in. The consequences are there will be no return on your investment as those bonds may become worthless. 

This is an important reason to hold physical Gold and Silver as they are sound vehicles without any counterpart risk. 

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