Review the article, write a section to discuss the powerful role central banks play in bond markets
Primer on Big Debt Cycles Use the the Primer to better understand trends in the credit markets RAY DALIO ON BIG DEBT BUBBLES During economic expansion, debt rises with wages and A recent book written by Ray Dalio, a renown global investor, income. entitled Principles for Navigating Big Debt Crises, provides a recounting and analysis of the common elements and causes of Income peaks at the end of an expansion while debt over- past big debt crises. Normally, a book like his would be sidelined shoots and continues to grow. as econobabble from purely theoretical economists. However, Dalio's credibility as one of the most principled and successful Income begins to fall, reducing the ability to pay debt ser- investors of our time compels any reasonable investor to seri- vice payments. ously consider his ideas and ponder his conclusions. Dalio is a bit of an economic renaissance man. The invest Debt peaks and begins to fall as debtor insolvency leads to ment firm he founded, Bridgewater Associates, is one of the defaults. most successful investment firms of all time. As an investment manager, Dalio is a learner. He believes investment management Defaults strain capital within the financial system and reduce is a principles game where failure, and learning from failure, economic performance. constitute the most powerful determinants of success. A more detailed account of Dalio's and Bridgewater's invest in extreme cases, financial institutions fail without access to ment approach can be found in his book. sufficient capital to meet their obligations. In the next section, we will review the three categories of debt: DEBT CRISES DEFINED household, corporate, and government. A debt cycle occurs when people, companies, and countries become insolvent and can no longer pay their debt service costs. Debt crises are nothing more than aggregate insolvency of indi- CATEGORIES OF DEBT viduals, companies, and governments en masse. Governments Household Debt are usually the last group of creditors to become insolvent Household debt has a significant impact on the U.S. economy because of their ability to print money, as a last resort, to pay since 70% of U.S. economic production comes from consumer debtors. spending. During economic recessions, consumers tend to pay Debt cycles typically follow general economic cycles. off their credit cards, reduce spending, and increase savings. Economic growth generates wage prosperity through higher The Credit Crisis had a wrenching impact on U.S. households wages. As wages rise, debt capacity rises as well. Toward the end resulting in significant deleveraging. Household debt, as a per- of an economic cycle, wage growth peaks, followed by a debt cent of household disposable income, is at its lowest level since peak. Economic contractions cause wages to begin to fall and 1980. American household balance sheets are healthier than insolvency sets in. Insolvency can only be solved by increasing they have been for a generation. income or decreasing debt. In a low interest rate environment, borrowing money is a bet US Household Debt as a Percent of Household ter financial decision than using savings. For example, the S&P Disposable Income 500 has generated an annualized return of 11.85% since January Shaded Areas Are Recessions 2009 and mortgage rates are, on average, 6.2%. Households, 13.5% 100 13.5% 13.0% 12.5% 120% 2009 and mortgage rates are, on average, 6.2%. Households, therefore, would be better off borrowing money to buy a house and investing their savings in the stock market than using their savings to buy a house. But, since debt never sleeps, never gets sick, and never loses a job, the low cost tax shield of debt that improves financial performance during expansions jeopardizes performance in recessionary environments. After researching 48 big debt cycles, Dalio has simplified them into seven broad stages. While his stages are instructive, the key elements of debt cycles are fairly straightforward and can be explained in six stages. M 115% 110% 10.5% 10.0% 9.5% Mar-90 Mar-82 Mar-84 Mar-86 Mar-88 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-2 Mar-14 Mar-16 Mar 18 Bloomberg L.P. FIXED INCOME ANALYSIS & VALUATION Corporate Debt Since the Credit Crisis, U.S. corporate balance sheets appear Financial and non-financial firms use debt in different ways. to have embarked on a pattern of deleveraging. To better under- For a financial firm, such as a bank, debt is a direct source of stand this pattern, we need to separate the corporate sector into capital that can be used to generate revenue through lending. financial and non-financial companies. For a non-financial firm, debt is used to purchase capital assets The following graph charts U.S. financial company debt as which are then used to produce goods that can be sold to gen- a percent of gross domestic product. While it shares the gen- erate revenue. eral deleveraging shape and trend of the total corporate graph In 1980, financial firms accounted for 12% of total corpo- above, the acceleration of indebtedness among financial firms, rate profits. As of the first quarter of 2019, they account for which is almost exclusively related to the advent of financial 20%. From 1980 through the end of the Credit Crisis, securiti- securitization which began in earnest in 1989, seems almost zation catalyzed a process called financialization where finan- devoid of the plateaus indicative of normal business cycles. cial assets, like mortgages, were moved from banking systems, The period of deleveraging following the Credit Crisis, coin- where they were tightly regulated, to the capital markets where cides with a significant reduction in the securitization market they are poorly understood. Financialization was a primary and the balance sheet stress related to securitization. cause for increased debt in financial companies. Financial Corporate Debt-to-GDP Finance Profits as a Percent of Total Corporate Shaded Areas Are Recessions Profits Shaded Areas Are Recessions 140% 120% 100% 40.0% 35.0% 30.0% 25.0% 80% Momalo TUTUVU VE Focorpore 140% Profits Shaded Areas Are Recessions 120% 100% 80% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% Mun 60% 40% 5.0% 20% 0.0% 0% -5.0% -10.09 Mar-80 Mar-82 Mar-94 Mar-36 Mar-38 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar- Mar-12 Mar-14 Mar-16 Mar-18 Mar-82 Mar-84 Mar-86 Mar-88 Mer-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 With financial companies removed, the cyclical impact of On a company-by-company basis, leverage can be measured business cycles on non-financial balance sheets is much more using financial ratios like debt-to-assets. When assessing aggre apparent. The graph on the following page clearly shows that gate corporate leverage, it is common to look at corporate debt- peak balance sheet leverage-to-GDP ratios coincide with reces- to-GDP. As the graph on the next page illustrates, after each sionary periods, at least over the last three economic cycles. recessionary period, there is a pause and then a burst of lever- Some caution is warranted here. What companies do with the age. Lower interest rates, which have been a trend since the debt matters. early 1980s, have pushed financial managers to increase the During the recession of 1980, corporate debt was mostly tra- proportion of debt in their capital structures. However, as the ditional and economic cycles of boom and bust were the result graph below illustrates, something happened in 2008-09, during of overbuilding capacity, funded by debt. During the internet the Credit Crisis, that reversed the trend of increased leverage. boom, debt was used to acquire companies with spurious eco- nomic viability. More recently, leading into the Credit Crisis, U.S. Corporate Debt-to-GDP increased indebtedness fed a real estate market on steroids. In Shaded Areas Are Recessions each of these three economic cycles, increased leverage was used to fund non-performing assets. The current run of non-financial corporate indebtedness is being used to fund share buy-backs which are, by their nature, existing and performing assets. I 180% 160% 140% 120% HI 100% 80% 60% 40% Mar-82 Mr-84 Mar 86 Mer-88 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-0 Mar.12 Mar. 14 Mar. 16 Mar. 18 Bloomberg L.P. Non-Financial Corporate Debt-to-GDP Shaded Areas Are Recessions U.S. Government Debt Divided by Tax Receipts Shaded Areas Are Recessions 50% 120 45% 10.0 40% 35% 30% 2.0 25% 20% Government Debt Most governments around the world have been on a borrow- ing spree over the past decade. Initially, increased government indebtedness was blamed on the need for government interven- tion following the Credit Crisis. But since then, increased deficit spending has forced governments to continually increase their debt. It is common to measure national government debt by comparing it to the country's gross domestic product. A com- parison of countries below shows some real outliers. The debt numbers included in this analysis only include explicit indebt- edness. Social Security, Medicare, Medicaid, and unfunded pen- sion liabilities are not included. National Debt-to-GDP 250% 236% 200% 150% 1329 111% 98% 97% 87% 84% 82% 100% 70% 84% 48% 42% 50% 0% 0% UK US Brazil Japan India Singapore Spain France Germany China Australia Hong Kong National Debt-to-GDP 250% 236% 200% 150% 132% 111% 100% 98% 97% 87% 84% 82% 70% 64% 48% 50% 0% 0% US Japan Italy Singapore Spain France UK Brazil India Germany China Australia Hong Kong Governments pay debt service using tax receipts. Consequently, comparing the U.S. government's debt burden to its tax receipts can be a useful measure to understand its current level of indebt- edness. Forty years ago, in 1980, the U.S. government's debt was 2.58 times its tax receipts. Today, the same ratio is 10.91. The take home lesson for the United States is that the burden of govern- ment services currently being provided to its citizens is being shifted to another generation through increased indebtedness
