Neither a Borrower Nor a Lender Be, by Robert Gore

In a debt deflation, you do not want to be in debt. Income and liquidity with which to service your debt shrinks. Deflation increases the real burden of repayment, the opposite of inflation, which devalues the means of repayment and thus works in favor of the debtor.

You do not want to be a creditor, either. There are two risk components of interest rates: rate risk, the risk that rates in general rise, and credit risk, the risk that the borrower does not repay. While interest rates for the most creditworthy borrowers may stay low, for any borrowers for which there is even a hint of doubt about ability to repay, the risk premium over perceived riskless debt rates widens and the interest rate skyrockets. Widening risk premiums and skyrocketing interest rates adversely affect the price of the underlying debt, inflicting losses on creditors. If the borrower defaults, the loss can be the entire investment.

Risk premiums have already widened significantly on the debt of natural resources companies and for emerging market governments and companies. They are nowhere near the levels reached in the last financial crisis, so it is not too late to sell, because they will probably attain and surpass those levels.

Turning to other debt, there is no better candidate for sale than municipal bonds. Such debt is an investor favorite because most municipal interest is either tax-advantaged or tax free. Historically, default rates on municipals have been low. However, if the stock market knows what it is talking about and the economy is heading into a recession or worse, state and local governments’ income, property, and sales tax collections will be reduced, just as they were during the last crisis. The demand for services, particularly the social safety net and policing—crime increases during economic downturns—will increase. Revenues down and spending up means that the ability of governments to pay their debts deteriorates.

There’s another consideration. A significant portion of governments’ pension and medical liabilities are unfunded. Estimates of the aggregate state and local shortfall range from $1 to $4 trillion. With a shrinking economy, governments will have less money to either make current payments into pension and medical funds or make up for past shortfalls. Not only that, but those funds’ investment returns are plummeting. Low interest rates have been a problem, but now they must contend with falling equity markets, too. Diminishing revenues, increased demand for government services, huge unfunded liabilities which are only going to get bigger—selling municipal bonds is as close to a no-brainer investment decision as the financial markets are ever going to hand you.

The case for selling corporate bonds is almost as compelling. There are a few triple A, gold-plated corporate credits that can probably survive anything short of the destruction of the planet. They will be in such demand that the interest they pay will be minimal. The vast majority of corporations will be operating in a shrinking economy, and that means shrinking revenues, profits, and ability to service their debt.

The dirty secret of the latest bull market is the games companies have been playing with their own stock. Stock bulls constantly point to cash on corporate balance sheets and rising earnings per share as reasons to buy. What they don’t point out is that many corporations, in the name of “shareholder friendliness” have either been spending the bulk of their profits, or all of their profits and going into debt, to buy their own shares and pay dividends. That balance sheet cash is borrowed and the rising earnings per share are because the share count, the denominator in earnings per share, has shrunk. In many cases gross revenues and total profits have been stagnant or declining.

The low interest currently being paid on most investment-grade (BBB or better) municipal and corporate bonds offers little compensation for their rising credit risk, making the decision to sell that much easier. While the credit rating agencies have their gradations for the creditworthiness of various bonds, the market often applies a simpler test: is a bond going to pay or not? If it decides payment is in doubt, the market quickly and substantially marks down the price of the questionable bond, leaving holders no way out without hitting fire sale bids and sustaining painful losses.

This analysis applies to municipal and corporate bonds only. The day will come when markets question the creditworthiness of US government bonds and debt securities with US government guarantees (they certainly should), but we’re not there yet. For the time being, the US government’s debt and guarantees are regarded as the benchmark of creditworthiness and that will probably continue for a while. We will know things are changing when interest rates on government debt show a sustained increased in the face of economic contraction and deflation.

During the last financial crisis and recession, many municipal and corporate bonds were subject to precipitous drops. Even as the crisis unfolded, most investors found it inconceivable that stalwart industrial and financial companies would go bankrupt or require government rescues, but they did. This time the window for selling corporate and municipal bonds is still open, but once the herd realizes that financial turmoil and economic contraction will impair the ability to pay across broad swaths of the bond market, it will snap shut.


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7 responses to “Neither a Borrower Nor a Lender Be, by Robert Gore

  1. Pingback: SLL: Neither A Borrower Nor A Lender Be | Western Rifle Shooters Association

  2. Deflation and the declining value of everything (except food) suggests a very hard reset. I was more prepared for inflation, but both end badly. It’s just a different “road” to the same default destination. Preparing for a deflation is also more difficult, IMO.


  3. So how does this work? Historically AAA corp are about 50 basis points over the TBill rate. Under the current scheme of Fed ZIRP corporate rates are lower than they have ever been. The Fed will continue ZIRP as long as they can because if 5yr TBills even sniffed at 2% or higher the govt could not afford it. Programs would have to be sacrificed to cover the increased debt load. With that level of underlying resistance I don’t see how corp rates rise.

    I suspect something quite different to occur. Credit Default rates will rise even as the the base rates remain flat. That does not mean business as usual. As you suggest, lending will be restricted under advise of the counter parties or the risk cover will be withdrawn. Which means the banks will lend grudgingly to AAA to AA+ borrowers and all other can suck canal water. To further reduce risk, banks will start back pedaling on consumer lending, principally credit cards where their largest exposure lies. So the general rule will be if you can get credit it will be cheap. But the ability to qualify will be extremely aggressive. That bodes ill for any industry dependent on credit lines.


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