November 16, 2020
COVID-19 cases keep rising in the U.S… just as fall and cooler temperatures have arrived.
Here in Maryland, Governor Larry Hogan held a press conference last week, announcing the state would revert back to tighter restrictions for COVID safety.
Looks like we’ll all be hunkering down for a long, cold, dark winter.
And what about the businesses who are barely hanging on from the spring and summer pandemic lockdown? Many companies are borrowing just to keep the doors open and debt levels are rising. These levels will keep rising as long as the economy is unable to get back to normal.
This situation is putting a ton of pressure on businesses’ capital structures…
Not every company will survive. Many are starting to collapse, and the trouble will keep getting worse. And yet, investors don’t seem too worried about the dangers…
To dive into this today, we’ve got Stansberry Research senior analyst Mike DiBiase. Mike is an analyst and former CPA and Big Four auditor with more than 20 years of experience in financial management and accounting. Before Stansberry, Mike was vice president of Finance & Planning for a large publicly traded software company.
A vast wave of bankruptcies has begun… Mike believes we’re in the early phases of a slow-motion disaster – and as things get worse, many unsuspecting investors will be wiped out…
Be Warned… The ‘Debt Dams’ Are Breaking
By Mike DiBiase
It doesn’t seem possible that 2020 could get any worse…
In addition to a global pandemic that has upended our daily lives, leaving millions of folks without jobs, we’ve seen rioters destroy parts of several U.S. cities… a record number of hurricanes… devastating fires along the West Coast… just to name a few.
But with all that’s going on, I bet you haven’t heard about a looming disaster in China. The world’s most populated country is enduring its worst flooding in decades…
This past summer, China was deluged with a prolonged period of heavy rain. The China Meteorological Administration issued heavy rain warnings for more than 30 straight days.
As a result, the world’s largest dam is now in danger of collapsing…
The Three Gorges Dam in central China sits on the Yangtze River. The dam is five times bigger than the Hoover Dam in Nevada, spanning 7,700 feet with a height of more than 600 feet. It’s also the world’s largest hydroelectric power plant.
The reservoir behind the dam holds 42 billion tons of water… When the dam is full, it’s so much water that its concentrated weight slows the Earth’s rotation by 0.06 microseconds.
The Three Gorges Dam was completed in 2006. At the time, China’s state-run media outlets boasted that it could withstand the worst flood in 10,000 years.
Now, just 14 years later, it’s in jeopardy of being washed away…
Continued heavy rain has caused the Yangtze River to swell. Water levels have risen to 175 meters recently – 28.5 meters above the Three Gorges Dam’s warning level. The enormous weight of the water behind the dam has caused landslides along the reservoir.
Experts outside of China have closely tracked the situation… Satellite images even before the weeks of rain this year seemed to show that the dam had bent slightly.
In late July, the Chinese government—which initially said the issue was with the satellite images and not the dam–finally acknowledged that the dam had “deformed slightly” from the recent flooding. Operators maintain that it’s still safe despite the defects… But the danger is far from over.
And it would be truly devastating if the Three Gorges Dam were to collapse…
Tens of millions of people live downstream from the dam along the Yangtze River, including the large populations in Wuhan and Shanghai. If the dam fails, hundreds of thousands of people will likely die… and millions more will probably see their homes washed away.
Critics of the Three Gorges Dam believe concrete and steel bar welding used to build the dam were substandard. China’s state-run media no longer believes the dam could survive the worst flood in 10,000 years. It revised the claim all the way down to 100 years… a major loss of confidence in the dam’s strength.
Now, I’m not a structural engineer. I can’t tell you whether or not the Three Gorges Dam will ever collapse… or whether it’s within years, weeks, or even days of a catastrophe. I certainly hope not… No one wants to see millions of people lose their homes or worse.
But I am an analyst who tracks what’s going on with the credit markets. And as I read about the dangerous water levels at the Three Gorges Dam, it reminds me of how the COVID-19 pandemic is exacerbating our debt problem…
The COVID-19 pandemic is a lot like the storms in China, dumping endless pain on the global economy…
Government and corporate debt levels are rising steadily, day after day… much like the waters along the Yangtze River. With most businesses’ sales down significantly due to the shutdowns, they’re forced to borrow just to pay the bills.
The longer COVID-19 keeps the world’s economies shuttered – or at least slowed – the higher the debt “floodwaters.” This rising debt is putting massive pressure on companies’ capital structures.
Not every company will be able to withstand the pressure. Many “debt dams” will break.
You can think of a debt dam as a divider between a company’s debt and equity… It separates a company’s debtholders from its stockholders.
Think of the company’s stockholders as the folks who live just down the river from the dam. The company’s debtholders live above the dam, near the reservoir. The flow of water in the river is the capital that the company needs to flourish.
The debt dam brings a lot of benefits…
First, it keeps the stockholders from flooding by giving the large amounts of capital a safe place to accumulate. In other words, when companies want to raise cash, they can use their reservoir of debt. By using debt to raise the capital, stockholders aren’t flooded with new shares of stock every time the company needs cash.
The debt also acts like a power generator for corporate earnings… It allows companies to produce much higher profits on a given amount of equity investment.
Let me give you a quick example to show you what I mean…
Assume a brand-new company needs to raise $100 million in new capital to invest in a business that will earn $20 million per year in operating profits.
The company has a choice… It can raise the capital by issuing new equity (stock), by issuing new debt (using the reservoir), or some combination of the two options.
First, let’s assume the company raises the $100 million by issuing stock. If the stock is valued at $10 per share, it will issue 10 million shares and its after-tax profits will be $16 million (assuming a 20% tax rate). Its earnings per share will be $1.60 ($16 million in profits divided by 10 million shares). That’s a 16% return on equity ($16 million divided by $100 million in equity).
Now, instead, assume the company raises half of the $100 million by issuing debt at a 6% interest rate. Instead of issuing 10 million new shares, it will issue only 5 million. Because it now must pay interest on the debt, its after-tax profits will be a little lower ($14 million).
But here’s where the power of leverage comes in…
While the company’s after-tax profits are 13% lower when using debt, its earnings per share will be 75% higher. Earnings per share will be $2.80 ($14 million in profits divided by 5 million shares) compared to $1.60 using all equity. The company’s return on equity is also 75% higher… it jumps to 28% ($14 million profits divided by $50 million in equity) by using debt from 16% using all equity.
The 75% increase in earnings per share and return on equity is the same no matter what you assume the company’s stock is worth. That’s because when a company uses debt as a source of capital, it has less equity outstanding, so its earnings per share and return on equity are much higher. That makes a tremendous difference.
By issuing debt instead of shares, the company can supercharge its return on equity and earnings per share.
The following table shows the differences between the company’s profits, earnings per share, and return on equity ratios under the two different scenarios. Take a look…
The more leverage (debt) used, the higher the returns. That’s why the management teams at most corporations love debt so much. It’s a way to amplify their profits and returns.
The problem, of course – as with most things in life – is excess…
Too much of a good thing becomes dangerous… The extra leverage brings added risk. When the sun stops shining, the debt doesn’t go away. It still must be repaid.
That’s exactly the problem facing many companies today. They were already levered to the hilt even before the COVID-19 pandemic began… U.S. corporate debt was at an all-time high, both in nominal dollars and as a percentage of gross domestic product.
And now with the economic downturn caused by the COVID-19 pandemic and related shutdowns, corporate debt piles are growing dangerously larger. Corporate debt has ballooned to an all-time high of $11 trillion. Back in 2008, corporate debt was only $6.6 trillion.
Like the Chinese government officials operating the Three Gorges Dam amid prolonged periods of heavy rain, companies hope the COVID-19 “storm” passes quickly. But immense pressure is building. Their debt dams are fast approaching the point of failure…
Many will collapse.
When a debt dam breaks and a company goes bankrupt, it completely wipes out all equity. The debtholders take over what’s left.
Companies may emerge from bankruptcy at some point down the road, but they only do so with new owners.
Unfortunately, the economic storm isn’t likely to subside. The spread of COVID-19 isn’t slowing down… We’ve reportedly eclipsed 52 million cases globally, including 10.5 million in the U.S. Plus, it’ll probably get worse before it gets better… The spread of the virus is starting to accelerate again as we head into the winter flu season.
And the longer we’re dealing with the threat of COVID-19, the more debt dams that are in danger of collapsing. That’s why I believe a vast wave of bankruptcies is approaching…
In fact, we’re already starting to see this play out across corporate America…
According to credit-ratings agency Standard & Poor’s (“S&P”), 129 U.S. companies defaulted on their debt so far this year… the most since 192 defaulted in 2009.
And unfortunately, this is just the beginning. Things will get much worse…
We can see what’s coming by looking at the number of companies whose credit has been downgraded. Downgrades are an early warning sign… They always come before defaults.
So far this year, S&P has downgraded the credit of more than 2,100 companies, including more than 1,000 in the second quarter. That’s already more than any year on record. Take a look…
This tells us clearly that we’ll see many more defaults in the months ahead. Today, the default rate is around 6% – up from 3% at the start of the year. That means 6% of all U.S. corporate borrowers have defaulted over the past year.
And it’s clear that this number is headed higher when you look at the “weakest links”… Weakest links are companies with already-poor credit ratings (“B-” or lower) that are on negative credit watches or with negative credit outlooks from S&P.
The number of weakest links in the U.S. is now more than 400 companies. That’s nearly double the 235 weakest links in March 2009 during the last financial crisis.
Here’s why that’s important… The default rate for the weakest-link companies is around five times higher than the overall default rate.
In other words, we can expect the default rate among weakest links to soar soon… and the overall default rate to follow. When the default rate soars, investors panic.
It only takes one small part of a dam to fail for the entire structure to collapse. In the same way, it’s only a matter of time before the credit market collapses.
I believe we’re still in the early phases of a slow-motion disaster…
We’re just seeing the initial cracks in the side of the dam today. The real damage hasn’t even been done yet. The numbers are about to get much, much bigger…
S&P forecasts that the high-yield default rate will rise to 12.5% by June 2021. That would be the highest default rate since the Great Depression in 1932.
S&P’s current “pessimistic” forecast projects the default rate to reach 15.5%. A 12.5% default rate means another 240 companies will go bankrupt over the next year. A 15.5% rate means more than 300 companies will go under. So as you can see, the storms will likely get much worse.
And yet, investors don’t seem worried at all about what’s happening…
After plunging more than 30% in about a month earlier this year, the benchmark S&P 500 Index charged to new all-time highs in late summer. And although it has been volatile since then, the trend is up again… And the market is once again flirting with an all-time high.
Debt investors don’t seem to be concerned with the approaching storm clouds, either…
The best way to gauge fear in the credit market is by looking at the high-yield credit spread. It’s the difference between the average yield of so-called “junk” bonds and the yield of similar-duration U.S. Treasury notes. When the spread is low, investors aren’t concerned at all about defaults. When it’s high, they’re worried about getting paid back.
The spread has fallen to around 460 basis points (“bps”) today. It’s once again below its long-term average of around 600 bps, after rising to more than 1,000 bps in late March… a few weeks after the World Health Organization declared COVID-19 a global pandemic.
The lack of worry among investors right now is concerning…
The Federal Reserve won’t bail out every company. Its efforts to help most businesses so far were only done to instill confidence in the credit markets. The Fed has prevented credit from drying up. But in reality, it’s just extending the day of reckoning for many companies.
The excessive debt balances can only continue to rise for so long. Eventually – and in most cases, suddenly – companies collapse. Unsuspecting investors will be wiped out.
I’ve shown you the warning signs of record levels of corporate debt… record numbers of corporate downgrades… and all-time highs in the number of weakest links.
It’s only a matter of time before many more debt dams break. Consider yourself warned.
P.S. In the monthly newsletter Stansberry’s Credit Opportunities, Mike and his colleague Bill McGilton keep subscribers updated on what’s happening in the credit markets at any given moment. They are constantly searching for the best, lowest-risk ways to profit in the space.
And most important, they break everything down in a way that’s easy to understand… So even if you’ve never stepped outside of stocks before, you’ll learn exactly how it all works.
In fact, Mike and Bill just put together a brand-new report called, “Your Complete Guide to the Coming Credit Collapse.” It details why the next crisis will be much worse than those in the past… and highlights three of his favorite ways for you to profit right now.
But you don’t have to just take our word for it… One of Stansberry’s longtime subscribers shared his own experiences with our corporate-bond research. And we guarantee you don’t want to miss what he had to say. As you’ll see, it could change your life forever. Learn more here.
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Managing Editor, American Consequences
With P.J. O’Rourke and the Editorial Staff
November 16, 2020