Less Debt? Less Leverage? It's Practically Un-American!
Last Thursday the Federal Reserve published confirmation of a trend we have been seeing for a few quarters, that is, corporate America is taking on marginally less debt and leverage could be moderating. This trend is practically un-American, as corporate leverage has been ticking up for decades!
Moderating leverage is great for corporate bond investors and is one of the reasons why we still like investment grade corporate bonds this late in the credit cycle. In addition to moderating leverage, corporate bonds are benefiting from higher corporate earnings, very high levels of technical demand (as central banks keep interest rates low) and credit spreads that continue to tighten yet are still relatively attractive compared to other fixed income options. We call it the credit Indian summer–great while it lasts.
It is not quite clear what CFOs are thinking and if the recent moderation of leverage is a durable trend. Current beliefs about the optimal corporate capital structure are still widely influenced by Franco Modigliani (a 1985 Nobel Prize winner), whose groundbreaking work with Merton Miller made the argument that corporations could increase their value by substituting debt for equity. Debt is cheaper than equity and interest payments are tax deductible. This academic endorsement of leverage is, we believe, the underpinning to Michael Milken, the rise of the junk bond markets, private equity and LBOs, and perhaps even to the banking crisis of 2008. Pretty influential for a professor!
This early trend of moderation in leverage may nonetheless have legs. Interest rates around the world have likely bottomed, and even slowly rising rates mixed with high leverage is uncomfortable for CFOs. Also, the corporate bond market now has more BBB than A ratings, and the migration from BBB to BB is usually quite painful. The government’s tax reform proposal may reduce or eliminate the tax deduction for debt. And finally, perhaps stock buybacks and dividend increases are losing favor compared to investments that actually grow revenue and income.
Call us old fashioned, or just plain conservative, but we do think it would be very American to grow the value of companies through investments in productive assets, people and processes all funded with cash flow, rather than just increasing stock values with the use of leverage.
Source: The Wall Street Journal, The Federal Reserve, Bank of America Merrill Lynch
Why Lasting Change Is Hard
Before we had any children, my wife and I lived in the heart of Dallas. One day, on our way back to our house, we were driving down Skillman Avenue when we were caught in a sudden torrential downpour.
The rain was coming down incredibly hard, which wouldn’t have been a problem if the storm drains were equipped to handle that much water. Instead, the road itself filled with water faster than we could have anticipated. Quickly, the water rose up the side of our car. Trying not to panic, we realized that we could not continue and would need to turn around and get to higher ground.
Water rising up the side of your car door is the kind of roadblock you might not expect to encounter, but when you do, it’s formidable. We couldn’t drive through it or even around it. We had to deal with it quickly or face serious consequences.
When we’re trying to implement change in our own lives, it’s important to identify and plan for common roadblocks to lasting change.
The first and, in my opinion, most important roadblock to lasting change is not addressing the real issue.
Let’s say you wake up in the middle of the night with a sore throat. You’re annoyed by feeling sick but your throat really hurts, so you get up and spray a little Chloraseptic in your mouth and drift off to sleep. When you wake up the next day, you still have a sore throat, so you pop in a cough drop and go about your day.
The change you’re making – using a numbing agent – might work if you’ve only got a cold, but if it’s strep throat, you’re not addressing the real problem. Only an antibiotic will cure what ails you, even if Chloraseptic will keep the pain at bay for a while.
Just like how more information is needed to diagnose your sore throat than one feeling, problems you encounter in your life or business require diagnostics, too. Figuring out the real problem – not just your most apparent needs – requires some introspection and a little bit of time.
Here are eight questions to ask when you need to discover the root cause, courtesy of MindTools.com:
- What do you see happening?
- What are the specific symptoms?
- What proof do you have that the problem exists?
- How long has the problem existed?
- What is the impact of the problem?
- What sequence of events leads to the problem?
- What conditions allow the problem to occur?
- What other problems surround the occurrence of the central problem?
Once you have your answers to these key questions, you can’t stop there. Your vantage point is skewed from your own perspective. You’re going to want to ask someone else to evaluate the problem at hand with the same questions and then compare your answers.
If you and all of the partners at your firm have similar answers, you’ll know you’re on the right track. If you wind up with wildly different ideas, I suggest seeking the advice of someone outside your organization. Fresh eyes can make all the difference in understanding a problem.
I often talk about being ‘too close’ to understand. You’ve probably heard the illustration about a group of people standing by an elephant with blindfolds on, trying to describe what they’re experiencing. Depending on what part of the elephant you’re next to, you’re going to have different observations.
But someone outside of that elephant’s cage can clearly identify the elephant.
The first key to making a lasting change is to make sure you’ve addressed the real problem and are looking for authentic change.
Next time, we’ll address the second major roadblock to creating last change.
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