It's a simple fact that all else being equal, a company's profitability improves in accordance with how cheaply it can borrow money from investors in corporate debt markets. The steady decline in borrowing costs in the postfinancial-crisis period has allowed companies to refinance debt at cheaper rates (providing immediate improvements in the bottom line), in addition to buying back shares and funding acquisitions.
Borrowing costs, however, are likely as low as they're going to go and set to move higher in the latter half of next year. As Merrill Lynch quantitative strategist Marc Pouey noted in the company's most recent Research Investment Committee report, "we think that the fundamentals could turn more negative for corporate bonds as 2018 progresses, particularly if inflation rises more than we expect and the Fed is forced to raise rates more aggressively."
These "negative fundamentals" would take the form of lower corporate bond prices, higher corporate bond yields and higher borrowing costs for companies.
This change in trend will pose particular problems for capital-intensive market sectors such as utilities, telecoms and real estate, and it might also have negative implications for U.S. oil producers.
The accompanying chart compares the year-over-year change in the average profitability of S&P 500 companies, as measured by return on equity, with the change in high yield (in other words, low quality) corporate bond yields. In the latter case, the grey line represents the Merrill Lynch high-yield bond spread index, which shows the difference between high-yield corporate and government bond yields. For example, for the most recent data point of Dec. 22, 2017, the difference between the high yield bond yield and Treasury bond yield (the spread) declined by 14 per cent over the previous year.
I am not suggesting that borrowing costs are the only factor affecting broad profitability, but it is clear from the chart that higher corporate yields are associated with lower profits. The high-yield spread is still negative in year-over-year terms – corporate yields are still declining – but a trend toward year-over-year increases began in February, 2017.
Perhaps predictably in light of tightening corporate borrowing conditions, the rate of improvement in S&P 500 profitability peaked in mid-August and is now in a downtrend.
If Mr. Pouey is correct and corporate bond yields are heading higher in the second half of 2018, investors can expect deteriorating U.S. profit growth at the same time.
A weaker high-yield bond market would also form an important test of the ETF structure. Investors' hunt for income has led to extraordinary growth in the size of high-yield ETFs. In the case of the SPDR Bloomberg Barclays High Yield Bond ETF, its market capitalization has increased by more than 11 times, to more than $12-billion (U.S.) since the beginning of 2009.
The problem is that many corporate bond issues held by these funds are illiquid – it's difficult to find buyers during periods of volatility when the fund looks to sell its holdings (although importantly, this process is much different than for open-ended mutual funds). The risk is that once weakness in the sector begins, the lack of liquidity will lead to downward price spirals and severe investor losses.
We've been discussing U.S. markets, but rising corporate borrowing costs will also affect Canadian companies, although the domestic corporate bond market is small and sector-wide data are rarely, if ever, available. This is particularly true in the energy and mining industries, in which investor funds are constantly required to fund production increases. Debt-heavy utility stocks would suffer from higher borrowing costs as they refinance debt. Telecom and real estate companies would also be affected, to the extent that they could not offset financing costs with higher prices and rental income.
I grant that corporate bond markets are not an area that is top of mind for most investors. But financing costs matter to equity prices, a lot. There is, for an example, an extent to which the U.S. shale-oil revolution would not have been possible without cheap funds from debt markets, and we've seen how important shale production has been to the global energy industry.
Financing and debt costs matter to all companies and that's why, with inflation pressures potentially building, and both the Bank of Canada and Federal Reserve expected to raise policy rates three times in 2018, corporate bond spreads are among the most important market indicators for investors in the coming year.