Goldman Sachs Calms Fears About Rising Corporate Debt

Goldman Sachs

Many people, including some at the Federal Reserve, are worried about the high amount of borrowing companies are making. Goldman Sachs aren’t so worried.

In a note to investors on Tuesday, Goldman Sachs stepped up once again to look to allay fears of excessive corporate debt in the market, and in particular, the concern of so many BBB rated corporate bonds being in play now.

Not unlike how personal credit is rated, bond rating agencies take overall debt load into consideration, and having more debt relative to earnings negatively impacts a company’s rating to some degree, even though they of course take other relevant considerations into account.

Goldman Sachs also spoke up in response to the Fed’s recent warning about this issue, although they agree that caution needs to be exercised here. We do need to be paying close attention, but the amount of debt that a company has is only one factor, and we really do need to look at the whole picture to decide whether or not the risk involved in investing in bonds that are a little below what we historically preferred is worth taking on, or whether we are being properly compensated for it with the higher yields these bonds pay out.

The key calculation under examination is debt to earnings ratio, where more debt to earnings involves more default risk and will in itself cause lower ratings. Bond ratings are meant to provide guidance to investors, especially those who do not have the means to do their own research.

Individual investors for sure don’t have the wherewithal to perform this very well and will often times use the ratings as a cheat sheet to decide where to put their money. Institutional investors do have the means to do this but will still rely on bond ratings to some degree to shape their decisions.

It’s not that rating agencies don’t make mistakes, and sometimes make big ones, like their rating mortgage backed securities AAA, on par with treasuries, even though the two types of investments were about as far apart as you could possibly get before the MBS hit the skids.

Historically, MBS were very safe, although the changing environment leading up to the crash did dramatically alter the composition of these securities. All the extremely risky debt that was packaged in these securities ended up creating a time bomb that would inevitably explode, but this wasn’t accounted for in the ratings.

Corporate Debt is at Very High Levels These Days

Corporate debt is at its highest levels ever, and we might think that this is another red flag. Companies leverage themselves a lot more than they used to, and there are two big risks involved in this, the risk of a recession and the risk of interest rates rising.

When business drops off for any reason, this increases a company’s debt ratio, and when interest rates go up, this increases their cost of servicing the debt. Both increase default risk, and higher debt ratio simply mean more risk.

We therefore have more BBB corporate bonds out there than we ever had, which is at least a red flag as far as needing to keep an eye on both of these major risks that may cause some real trouble.

We may wonder why the market cares so much about interest rates and the actions of the Fed, and this is the main reason. Putting interest rates down reduces the cost of servicing corporate debt, leading to more profit for the company, and interest rates going up reduces their profit and even potentially puts the company’s solvency at risk if the company is already struggling and rates move enough.

With stocks, we care about performance a lot, but with bonds, we ultimately only really care that the ship doesn’t go down. If they are still afloat, they will meet their debt repayment obligations, but if they are insolvent, this is where we risk not getting paid the full amount promised to us.

Bondholders always come first, but there’s always the possibility that, in spite of companies striving to avoid default, it could happen. BBB rated bonds are comfortably above junk bonds. There is a sort of margin of safety in sticking to BBB bonds or better, but ratings can and do go down over time.

BBB Bonds Can Still Make Sense, If You Invest in the Right Ones

While we may not want to necessarily avoid BBB bonds, they do require keeping a closer eye on than higher rated bonds, especially if they get downgraded. That’s the real red flag, and if your bonds become reassessed as junk, you are taking on this additional risk without even being compensated for it by way of your yield.

All BBB bonds are not the same quality, and Goldman Sachs is preaching that we don’t avoid them, but be more selective with them. We want to pay particular attention to a business’ outlook, and a shortcut to that is to look at the outlook for the sector that they are in.

This makes sense because it’s only when things go south that this becomes an issue, and with bonds, it’s also how much things can deteriorate, so businesses that have a higher risk of excessive problems need to be treated differently.

Goldman Sachs are telling us to avoid what they see as risker sectors such as food and beverage makers, as well as health care companies and pharmaceuticals. They especially favor telecoms such as AT&T and Verizon, due to their efforts to reduce instead of increasing their debt load.

Debt load is in this sense dynamic, as it isn’t always enough to look at the present numbers. We also need to look at trends, rates of change over time, to get a better picture of where things may be headed.

BBB bonds now comprise over half of all corporate bonds, and one of the reasons why this all has taken off so much is the historically low interest rates that we have been maintaining. The good news is that we are quite a way from rates high enough to cause a lot of trouble, and while this landscape can change, our current economic projections make this quite unlikely anytime soon.

We also don’t want to become married to these bonds, and if the relationship starts to sour, it’s pretty easy to just walk away, just like it is with stocks. A lot of investors have a penchant to cling to both past the time that they reasonably should, but if you’re holding or considering buying BBB bonds, you do have to be willing to act if the situation calls for it, if the state of things deteriorate enough to have you worrying for valid reasons.

Goldman Sachs’ advice to not completely shy away from these bonds but to be more selective therefore seems pretty reasonable, although this will all depend on our objectives and risk appetite. We should not exclude them out of hand though, at least not right now.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.