Rising Corporate Leverage and its Impact on Asset Returns
Sam DeRosa-FaragJune 2016
Increasing Leverage as an Optimal Solution for Corporates and its Impact on Asset Returns
• After 2008, there was an expectation of a rapid decline in leverage. However, while leverage in the financial sector and the household sector declined, the corporate sector continued to increase leverage.
• Increases in perceived systemic risk and delinquencies led to declining leverage in the financial and household sectors respectively.
• Declining long term rates, inflation and economic growth, lower GDP volatility and lower corporate default rates encouraged US corporates to increase leverage.
• The resulting return pattern observed since 2000 has shifted the shape of the security market line into a convex vs. the more conventional upward sloping line. Unexpectedly, above average risk-assets underperformed medium risk-assets.
• Increasing corporate leverage has resulted in increased return dispersion with a higher uncertainty of returns.
2
Household Sector Debt as a % of GDP
0
20
40
60
80
100
120
Percent of GDP
14%
Source: Federal Reserve, Flow of Funds Table D1 via FRED
3
Financial Sector Debt as a % of GDP
0
20
40
60
80
100
120
140
Percent of GDP
Source: Federal Reserve, Flow of Funds Table D1 via FRED
4
US Corporate Debt as % of GDP
0
20
40
60
80
100
120
140
160
180Nonfinancial Corporate Debt as % of GDPPercent of GDP
153%
25%
69%
Source: Federal Reserve, Flow of Funds Table D1 via FRED
5
Lower GDP Volatility
16-Quarter Standard Deviation of Real GDP, % Change from Preceding Period, Quarterly, Seasonally Adjusted Annual RateSource: BEA and Eurostat
6
0
1
2
3
4
5
6
7
8
US and Euro Area GDP Volatility
USA Euro Area
USA: Average Q3 1950 - Q3 1985 USA: Average
Q4 1985 - Q4 20152.17
Euro Area: Average Q4 1998 - Q4 2015
2.14
US Inflation Since 1880
7Source: Robert Schiller
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%10-Year Annualized US CPI
Long-Term Rates: 10-Year Treasury Yield
8Source: Robert Schiller
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
G4 Nonfinancial Corporate Net Debt and Equity Issuance
9Note: $tr per quarter, G4 includes the US, the UK, the Euro area and Japan. Last observation as of Q4 2015.Source: ECB, BOJ, BOE, Federal Reserve flow of funds
Barclays US HY Index Quality Breakdown
10
Note: Market Values. Source: Barclays Research
Growing Share of Speculative Grade Issuers among US Corporates
20%
25%
30%
35%
40%
45%
50%
55%
60%
1981 1984 1985 1987 1989 1991 1994 1997 1998 2000 2001 2003 2005 2007 2009 2011 2015
*Total US rated corporate issuers = 3251 corporations . 1785 are sub-investment grade. Only 3 issuers are AAASource: S&P
11
Downgrade vs. Upgrades
12Source: Standard & Poor’s; 2013 data as of Q2 2013, JP Morgan
Downgrades have outpaced upgrades by a ratio of 2-to-1; S&P domestic issuers upgrades and downgrades
US Investment Grade Net LeverageUpward trend in US IG net leverage
Source: J.P. Morgan
13
Annualized returns and standard deviations based on monthly returns over stated period for following indices: 1/29/1988 – 12/31/1999The Trend line is fitted by the equation Y=ax + bX2 +c to the data represented by the blue diamondsSource: 3-Month T-Bill = GB3 Govt (Bloomberg) Index, US Treasuries = Barclays US Treasury Index, Barclays Agg = Barclays US Aggregate Index, HY = Barclays US Corporate High Yield Total Return Index, S&P = S&P 500 Total Return Index (Bloomberg: SPXT), GSCI = S&P GSCI (Commodities) Total Return Index, BB = Barclays U.S. High Yield Quality Distribution Ba Index, B = Barclays U.S. High Yield Quality Distribution B Index, CCC = Barclays U.S. High Yield Quality Distribution Caa Index, MSCI Japan = MSCI Japan Total Net Return Index (NDDUJN)
3Mo TBill
US 7-10Yr
Barclays Agg
HY
S&P
GSCI
BB
B CCC
MSCI Japan0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
0% 5% 10% 15% 20% 25% 30%
Annu
aliz
ed R
etur
n
Annualized Standard Deviation of Returns
14
Risk/Return Comparison 1988-1999
Annualized returns and standard deviations based on monthly returns for following indices from 1/31/2000 - 5/31/2016 (except PE)Data: PE = Cambridge Associates U.S. Private Equity Index (Quarterly, Q1 2000-Q4 2015); 1-3 Month T-Bill = Barclays 1-3 M T-Bill Index; US MBS = Barclays Aggregate Index: MBS component; Barclays Agg = Barclays US Aggregate Index; CS LL = Credit Suisse Leveraged Loans Index; TIPS = Barclays TIPS Index; UST 7-10 Yr = Barclays 7-10 Yr Treasury Index; BB = Total Return BB component of Credit Suisse HY Index; US CMBS = Barclays Aggregate: CMBS (ERISA Eligigble) component; B = Total Return B component of CS HY Index; HY = Credit Suisse HY Index Total Return; EMBI = JP Morgan EMBI Index Total Return; CCC = CS HY Index: Total Return CCC Component; S&P = S&P 500 Total Return Index, S&P Euro 350 = S&P Euro 350 Index: Total Gross Return; REIT = Dow Jones Equity REIT Total Return Index; GSCI = S&P GSCI (Commodities) Total Return IndexTrend line fitted by the equation Y=ax+bx2+c to the data represented by green diamonds. Straight line between single-B and CCC HY bonds
Risk/Return Comparison 2000-2016
15
US MBSTIPS
BB
CS LL Index
US CMBS
EMBI
B
S&P Euro 350
CCCS&P Industrial
MSCI Japan
S&P Energy
REIT
MSCI EM
GSCI
CS Leveraged Equity
S&P FinancialS&P Tech
PE
1-3 Month T-Bill
Barclays Agg.UST 7-10 Yr
HY
S&P 500
-2%
0%
2%
4%
6%
8%
10%
12%
14%
0% 5% 10% 15% 20% 25% 30%
Annu
aliz
ed R
etur
n
Annualized Standard Deviation of Returns
S&P Historical Bull And Bear Market Returns 1932-2008
Source: Bloomberg
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