David Swensen is one of America's greatest investors. As chief investment officer of Yale University, he has produced what has been described as an “unparalleled two-decade” investment record, averaging 16.1 percent annual returns for the school. What's most amazing about Swensen, however, is how unconventional he is. That he has been able to operate according to his theories unmolested is a remarkable achievement in itself. In the 1990s, while institutions and retail investors alike were literally gaga over domestic equities, Swensen had positioned nearly half of Yale's endowment — which is literally any school's lifeline — in illiquid, alternative investments, reducing exposure to U.S. stocks, at times, to less than 25 percent of the portfolio. (European equities exposure amounted to, at times, less than 15 percent of the portfolio in the decade.) His first book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, described the challenges to investing on behalf of a school, which typically depends upon its endowment to fund operations. Yale's investments were in alternatives, such as real estate, oil, timber and private equity. Why? Swensen made the point: Liquidity is overrated. It's expensive and never there when you need it.
For his outstanding results and his rather unconventional strategies, Swensen has understandably attracted much attention. By now you may be familiar with the fundamental premise laid out in his latest volume: Following the herd won't help individual retail investors make money. In fact, his new book, Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005), is an elegant rant against the giant mutual fund complex. The book paints an ugly — but convincing — picture of Wall Street as a necessary evil for retail investors. Basically, individual investors get a raw deal: Mutual fund companies “fail” their investors, are out for themselves, hit investors with egregious fees and excessive trading and engage in “slimy” practices, such as the use of soft dollars. His advice to your clients? Dump active management for a broadly diversified, passively managed portfolio by choosing well-constructed funds that mimic the Wilshire 5000 Index, the Lehman Brothers Government Bond Index and the MSCI EAFE Index. Oh, and rebalance often. In the excerpt below, Swensen describes the many risks facing corporate bond investors.
Many investors purchase corporate bonds, hoping to get something for nothing by earning an incremental yield over that available from U.S. Treasury bonds. If investors received a sufficient premium above the default-free U.S. Treasury rate to compensate for credit risk, illiquidity, and callability, then corporate bonds might earn a place in investor portfolios. Unfortunately, under normal circumstances investors receive scant compensation for the disadvantageous traits of corporate debt. At the end of the day, excess returns prove illusory as credit risk, illiquidity, and optionality work against the holder of corporate obligations, providing less than nothing to the corporate bond investor.
Corporate bond investors find the deck stacked against them as corporate management's interests align much more closely with equity investors' aspirations than with bond investors' goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility.
Provision of a safe haven justifies inclusion of fixed income in well-diversified portfolios. Unfortunately, in times of duress, credit risk and optionality serve to undermine the ability of corporate bonds to protect portfolios from the influences of financial crisis or deflation. In troubled economic times, a corporation's ability to meet contractual obligations diminishes, causing bond prices to decline. In declining-rate environments, caused by flight to quality or by deflation, bond call provisions increase in value, heightening the probability that companies call high-coupon debt securities away from bondholders. Sensible investors avoid corporate debt, because credit risk and callability undermine the ability of fixed-income holdings to provide portfolio protection in times of financial or economic disruption.
Historical returns confirm that investors received insufficient compensation for the array of risks inherent in corporate debt. For the ten years ending December 31, 2003, Lehman Brothers reported annualized returns of 6.7 percent for U.S. Treasury bonds and 7.4 percent for investment-grade corporate bonds. While index-specific differences in market characteristics and period-specific influences on market returns cause the comparison to fall short of a perfect apples-to-apples standard, the 0.7 percent per annum difference between Treasury and corporate returns fails to compensate corporate bond investors for default risk, illiquidity, and optionality. U.S. government bonds provide a superior alternative.
Don't Believe the Hype
Unfortunately, from a corporate debt investor's perspective, triple-A rated bonds can only decline in credit quality. Sometimes, bondholders experience a downward drift in quality to less exalted, albeit still investment-grade ratings. At other times, bondholders face a lengthy, Chinese-water-torture deterioration in credit that results in exile to the “fallen angel” realm of the junk bond world. On occasion, triple-A rated obligations maintain their standing. In no case, however, do triple-A bonds receive upgrades.
IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, at the time the largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor's perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Fourteen years later, IBM's senior paper carried a rating of single A, failing to justify both the rating agencies' initial assessment of IBM's credit and the investors' early enthusiasm for IBM's bonds.
Bond investors had no opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors faced the option of providing funds to the 1980s and 1990s IBM that needed enormous sums of cash. As IBM's business matured and external financing requirements increased, the quality of the company's credit standing eroded.
Contrast the slow erosion of IBM's credit to instances in which corporate credit quality declines dramatically. In early April 2002, WorldCom's senior debt boasted a single-A rating from Moody's, placing the fixed-income obligations of the telecommunications company firmly in the investment-grade camp. On April 23, Moody's downgraded WorldCom to triple B, one notch above junk status, as the company struggled with lower demand from business customers and concerns regarding accounting issues. A little more than two weeks later, following chief executive Bernard Ebbers's resignation, on May 9, Moody's chopped WorldCom's rating to double-B, junk-level status. According to Bloomberg, the firm thereby achieved the dubious distinction of becoming the “biggest debtor to ever be cut to junk.”
To the dismay of WorldCom's creditors, the rapid-fire descent continued. On June 20, Moody's assigned a rating of single B to WorldCom's senior debt, citing deferral of interest payments on certain of the company's obligations. One week later, Moody's dropped WorldCom's rating to single C, characterized by the rating agency as “speculative in a high degree.” In the middle of the following month, on July 15, the company defaulted on $23 billion worth of bonds. Finally, on July 21, WorldCom filed for the largest bankruptcy in history, listing in its court filing assets in excess of $100 billion.
WorldCom's transformation from a single-A credit, possessing “adequate factors giving security to interest and principal,” to a company in bankruptcy spanned less than three months. Most holders of bonds watched helplessly as the train wreck of WorldCom's bankruptcy demolished billions of dollars of value in what Moody's described as a “record-breaking default.”
During the final stage of the firm's death spiral, the WorldCom senior 6.75 percent notes of May 2008 fell from a price of $82.34 in the week before the Moody's downgrade to a price of $12.50 after the firm's bankruptcy. Owners of equity fared worse. From the week before the downgrade to the date of the bankruptcy, the stock price collapsed from $5.98 per share to 14 cents per share. Measured from the respective peaks, equity investors took by far the rougher ride. The WorldCom senior notes traded as high as $104.07 on January 8, 2002, resulting in an 88.0 percent loss to the bankruptcy declaration. Stockholders saw a price of $61.99 on June 21, 1999, creating a high-water mark that allowed investors to lose 99.8 percent to the date of the corporate demise.
Clearly, on a security-specific basis, WorldCom's collapse hurt equity holders more than it hurt debt holders, consistent with the notion that equity carries more risk than bonds. Yet, ironically, equity owners likely found it easier to recover from the WorldCom debacle than bondholders. The key to this apparent contradiction lies in the superior ability of a portfolio of equities to absorb the impact of single-security-induced adversity. Because individual stocks contain the potential to double, triple, quadruple, or more, a portfolio of equities holds any number of positions that could more than offset one particular loser. In contrast, high-quality bonds provide little opportunity for substantial appreciation. The left tail of the negatively skewed distribution of outcomes hurts bond investors in dramatic fashion.
The deterioration in IBM's ability to pay over more than two decades and the much more compressed collapse of WorldCom's credit standing mirrored a broader trend in the corporate debt markets. In recent times, corporate debt downgrades far outnumbered upgrades, forcing bond investors to manage against substantial headwinds. For the two decades ending June 30, 2003, Moody's Investors Service downgraded 5,955 debt issues while upgrading 3,412. In the last decade alone, $4.5 trillion of debt deteriorated in quality relative to the $3.4 trillion of debt that improved.
The across-the-board decline in credit standards stems in part from the past two decades' relentless increase in leverage in corporate America. On June 30, 1983, the debt-equity ratio of S&P 500 companies stood at 0.46, signaling that the constituent companies of the S&P 500 carried 46 cents of debt for every dollar of equity. As leverage increased in popularity, on June 30, 1993, the ratio reached 0.94. By June 30, 2003, the S&P 500 posted a debt-equity ratio of 1.37, indicating that debt levels exceeded the equity base by nearly 40 percent. As the level of corporate borrowings increased, the security of corporate lenders decreased.
Countering the impact of higher-leverage ratios, the two-decade decline in interest rates made debt more affordable. As ten-year U.S. Treasury yields moved from 10.9 percent in June 1983 to 6.0 percent in June 1993 to 3.3 percent in June 2003, the burden imposed by debt service obligations diminished markedly. Consider the ratio between the cash flow available to service debt and a firm's interest expense. At June 30, 1983, the constituent companies of the S&P 500 boasted $3.90 of cash flow for every $1.00 of interest expense. A decade later, the cash flow coverage ratio stood at an identical 3.90, indicating that the positive impact of lower interest rates offset the negative impact of higher leverage. By June 30, 2003, the ratio increased to $6.25 of cash flow per $1.00 of interest expense, representing a dramatic improvement. Obviously, as cash flows increased relative to fixed charges, the security of the bondholders increased commensurately.
Balance sheets and income statements tell different stories. Debt-equity ratios increased markedly over the past two decades, signaling deterioration in corporate credit. Cash-flow-coverage ratios improved significantly over the same twenty years, suggesting an improvement in corporate financial health. The question remains unanswered as to why during this period rating agency downgrades far outnumber upgrades.
The particular nature of companies that issue corporate debt may contribute to the surplus of downgrades over upgrades. The universe of corporate debt issuers consists of generally mature companies. Relatively young, faster-growing companies tend to be underrepresented in the ranks of corporate bond issuers, in many cases because they have no need for external financing. Bond investors cannot purchase debt of Microsoft, because the company sees no need to tap the debt markets for funds. Bond investors can purchase debt of Ford Motor Company, because the firm requires enormous amounts of external finance. If the group of corporate debt issuers excludes fast-growing, cash-generative companies and includes more-mature, cash-consuming companies, perhaps bond investors should expect to see more credit deterioration than credit improvement. Regardless of the cause, if history provides a guide to the future, bond investors can expect more bad news than good on credit conditions.