Rising Rates: Prepare Now for Defaults and Dividend Cuts
The long expected bond bear market as a result of rising rates is expected to begin and ravage over-indebted and low-growth companies.
With the Federal Reserve’s announcement Wednesday of a quarter point rate increase while signaling two more to come in 2017, investors should brace for the risk of a bond market collapse, particularly on high yield bonds, as well as the risk of dividend cuts by low-growth firms.
To be sure, the reason for the rate increase is a general belief that the global economic picture has improved and economy shows signs of overheating. “In view of realized and expected labor market conditions and inflation, the committee decided to raise the target range for the federal funds rate,” the Federal Open Market Committee said in its statement. “Near-term risks to the economic outlook appear roughly balanced.”
But in every rising rate cycle there will be firms that have taken on too much debt and can’t service debt or continue to pay an unsustainably high dividend. As rates rise, they will feel the pressure even as the Fed says rate rises will be “gradual.”
Notwithstanding, central bankers left unchanged their median projections for three quarter percentage-point increases in 2018, while the median fed funds rate estimate for 2019 rose to 3% from 2.9%, which means corporate credit quality will be at risk.
As a recent report by Morgan Stanley points out, falling rates have accounted for approximately 67% of investment grade credit and 25% of high yield returns in 2016. As rates increase, it stands to reason that the reverse will be true, and investment grade credit will decline.
In fact, the big headline of 2016 in bond markets that was probably crowded out by the election is that 2016 was an unprecedented year for corporate bankruptcies and defaults.
The number of firms worldwide that defaulted in 2016 reached 150, up more than 40% year-over-year. That makes 2016 the worst year for corporate stress since the height of the global financial crisis, according to ratings firm Standard and Poor’s.
Just over 40%, or 63, had been by oil and gas firms, with 50 of those also in the United States. Emerging markets had accounted for 28 defaults overall, followed by Europe at 12.
Of the 150 defaulters in 2016, 56 issuers defaulted because of missed principal/interest/coupon payments, 40 due to distressed debt exchanges and 18 upon bankruptcy filings, while 14 were for “confidential” reasons.
Of course, Morgan Stanley rightly points out that for most fixed income investments, a small change in interest rates may not translate into a loss, as interest income offsets price declines. However, the bankers warn: “If interest rates go high enough, price declines overwhelm interest income,” and we know many experts that consider bond markets significantly overvalued.
Hedge fund titan Ray Dalio of Bridgewater fame said last year that it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets that would send them all much lower.
SHIELD: Defenders of Income
Given the potential for dividend cuts and defaults, since last year I have been advocating at our Personal Finance publication the need for investors to be more defensive because so much risk is baked into the market. Ultra-low Treasury yields have forced income investors into more risky assets. That has bid up prices, adding even more risk to the equation.
To address these risks, we placed Personal Finance’s Income Portfolio behind a system we call SHIELD, which stands for Secure, High-Yield Equities for Liquidity and Diversification. SHIELD has three goals: identify value, calculate risk and warn against threats to the dividend.
To deliver on these three goals, I developed three models that make up SHIELD. The first of our three models is our version of the Gordon Growth model. It calculates a stock’s value based on the dividends it will pay in the future. Also, the model calculates the intrinsic value of a stock, exclusive of current market conditions, which is especially valuable when markets are overvalued, as they are today.
The second of our three models is the safety rating system. This measures seven criteria, including a company’s earnings and credit quality, free cash flow and earnings-per-share growth. Together, these seven factors reflect a company’s ability to pay dividends. When we combine the results of the Gordon Growth model and the safety rating system, we get a share price forecast plus dividend safety.
The third model SHIELD uses is the Dupont Hybrid model. But stocks aren’t scored under this model, which acts as an early-warning system alerting us to a potential threat to the dividend. I developed and applied the model to Utility Forecaster several years ago. The Dupont model breaks a company’s return on equity into individual components that let us see what’s actually driving growth, such as profits or increased debt.
In coming days, I will share the results of the Dupont hybrid to alert investors on how companies far and wide will be affected by the continuing rising rate environment and how safe an asset’s interest payments and dividends are likely to be.