The Death of Leverage (and equities)

The single most empowering aspect of the boom that has just burst was the accommodating nature of leverage to allow anyone with the smallest amount of capital to take massive exposure to almost any investment opportunity and reap the resulting magnified benefits thereof. Leverage, however, is also the corrosive element that has (and will have eventually) destroyed the same swashbuckling investors now that the bubble has burst. The magnifying benefit of leverage in a bull market can also wipe you out when the tide turns.

The recent collapse of the commodity market was indirectly caused by the general deterioration of the global consumer environment but, directly caused by the evaporation of credit for the various hedge fund speculators who had pumped the market up in anticipation of an ever-increasing consumer demand for all things limited in supply (e.g. oil for cars & plastic, copper for house wiring, tungsten for consumer electronics, etc). However, the inflated values for all of these commodities was completely underpinned by the ability of these speculators to maintain leverage from financial institutions. When this could no longer be provided by the various financial institutions, the speculators had to unwind their positions. The equity market in general is no different...

Equity is, in essence, a leveraged investment. It is reliant upon a financial institution providing credit (or financing) to the business in order for equity investors to control and run a large operation for a much smaller investment. In buoyant times of cheap financing, this is very advantageous however, in more economically challenging times, the access to this financing is very difficult. The return on cash invested seen by equity investors over the past few years will not be seen for many years to come. Leverage is dead for now, and so with it, are the extraordinary equity dividend yields of yore. Leveraged companies will need to deleverage and even those with moderate leverage will find the cost of this leverage more expensive and therefore, an increasingly negative force on profits. Western world Inc will find it difficult to produce profits as it chooses between deleveraging or paying the increased interest cost on its existing debt. Bottom line, equities will produce little dividend over the next few years and should be considered only for their optionality on future profits.

So, if equities wont produce much return, what will...? Well, a step up the ladder on the corporate balance sheet is into its debt and, out of equity. No matter how much the company produces, its debt interest has to be paid - otherwise, it defaults and, goes into bankruptcy. In order for a company to survive, it must service (pay interest/coupons on) its debt. If leverage is dead and corporates must reduce their borrowing then, owning bonds (debt) in a company, which is able to continue business in this economic environment, is a fixed return in an ever-improving risk-profile. Either it continues to pay the interest or, it refinances and you get paid back. Either way (and especially for currently distressed companies) you get a decent return. The only caveat is to do your home work and pick the companies that will limp-on through this economic slump and still be here on the other side.

Bill Gross agrees - corporate bonds are the investment of the next few years. Whether you make an average return or a killing depends on whether you stick with investment grade companies that need little deleveraging or, you pick the right lottery numbers in the high yield universe. Eyes-down on the bingo cards!