Rising Corporate Leverage and its Impact on Asset Returns

Sam DeRosa-FaragJune 2016

Increasing Leverage as an Optimal Solution for Corporates and its Impact on Asset Returns

• After 2008, there was an expectation of a rapid decline in leverage. However, while leverage in the financial sector and the household sector declined, the corporate sector continued to increase leverage.

• Increases in perceived systemic risk and delinquencies led to declining leverage in the financial and household sectors respectively.

• Declining long term rates, inflation and economic growth, lower GDP volatility and lower corporate default rates encouraged US corporates to increase leverage.

• The resulting return pattern observed since 2000 has shifted the shape of the security market line into a convex vs. the more conventional upward sloping line. Unexpectedly, above average risk-assets underperformed medium risk-assets.

• Increasing corporate leverage has resulted in increased return dispersion with a higher uncertainty of returns.

2

Household Sector Debt as a % of GDP

0

20

40

60

80

100

120

Percent of GDP

14%

Source: Federal Reserve, Flow of Funds Table D1 via FRED

3

Financial Sector Debt as a % of GDP

0

20

40

60

80

100

120

140

Percent of GDP

Source: Federal Reserve, Flow of Funds Table D1 via FRED

4

US Corporate Debt as % of GDP

0

20

40

60

80

100

120

140

160

180Nonfinancial Corporate Debt as % of GDPPercent of GDP

153%

25%

69%

Source: Federal Reserve, Flow of Funds Table D1 via FRED

5

Lower GDP Volatility

16-Quarter Standard Deviation of Real GDP, % Change from Preceding Period, Quarterly, Seasonally Adjusted Annual RateSource: BEA and Eurostat

6

0

1

2

3

4

5

6

7

8

US and Euro Area GDP Volatility

USA Euro Area

USA: Average Q3 1950 - Q3 1985 USA: Average

Q4 1985 - Q4 20152.17

Euro Area: Average Q4 1998 - Q4 2015

2.14

US Inflation Since 1880

7Source: Robert Schiller

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%10-Year Annualized US CPI

Long-Term Rates: 10-Year Treasury Yield

8Source: Robert Schiller

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

G4 Nonfinancial Corporate Net Debt and Equity Issuance

9Note: $tr per quarter, G4 includes the US, the UK, the Euro area and Japan. Last observation as of Q4 2015.Source: ECB, BOJ, BOE, Federal Reserve flow of funds

Barclays US HY Index Quality Breakdown

10

Note: Market Values. Source: Barclays Research

Growing Share of Speculative Grade Issuers among US Corporates

20%

25%

30%

35%

40%

45%

50%

55%

60%

1981 1984 1985 1987 1989 1991 1994 1997 1998 2000 2001 2003 2005 2007 2009 2011 2015

*Total US rated corporate issuers = 3251 corporations . 1785 are sub-investment grade. Only 3 issuers are AAASource: S&P

11

Downgrade vs. Upgrades

12Source: Standard & Poor’s; 2013 data as of Q2 2013, JP Morgan

Downgrades have outpaced upgrades by a ratio of 2-to-1; S&P domestic issuers upgrades and downgrades

US Investment Grade Net LeverageUpward trend in US IG net leverage

Source: J.P. Morgan

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Annualized returns and standard deviations based on monthly returns over stated period for following indices: 1/29/1988 – 12/31/1999The Trend line is fitted by the equation Y=ax + bX2 +c to the data represented by the blue diamondsSource: 3-Month T-Bill = GB3 Govt (Bloomberg) Index, US Treasuries = Barclays US Treasury Index, Barclays Agg = Barclays US Aggregate Index, HY = Barclays US Corporate High Yield Total Return Index, S&P = S&P 500 Total Return Index (Bloomberg: SPXT), GSCI = S&P GSCI (Commodities) Total Return Index, BB = Barclays U.S. High Yield Quality Distribution Ba Index, B = Barclays U.S. High Yield Quality Distribution B Index, CCC = Barclays U.S. High Yield Quality Distribution Caa Index, MSCI Japan = MSCI Japan Total Net Return Index (NDDUJN)

3Mo TBill

US 7-10Yr

Barclays Agg

HY

S&P

GSCI

BB

B CCC

MSCI Japan0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0% 5% 10% 15% 20% 25% 30%

Annu

aliz

ed R

etur

n

Annualized Standard Deviation of Returns

14

Risk/Return Comparison 1988-1999

Annualized returns and standard deviations based on monthly returns for following indices from 1/31/2000 - 5/31/2016 (except PE)Data: PE = Cambridge Associates U.S. Private Equity Index (Quarterly, Q1 2000-Q4 2015); 1-3 Month T-Bill = Barclays 1-3 M T-Bill Index; US MBS = Barclays Aggregate Index: MBS component; Barclays Agg = Barclays US Aggregate Index; CS LL = Credit Suisse Leveraged Loans Index; TIPS = Barclays TIPS Index; UST 7-10 Yr = Barclays 7-10 Yr Treasury Index; BB = Total Return BB component of Credit Suisse HY Index; US CMBS = Barclays Aggregate: CMBS (ERISA Eligigble) component; B = Total Return B component of CS HY Index; HY = Credit Suisse HY Index Total Return; EMBI = JP Morgan EMBI Index Total Return; CCC = CS HY Index: Total Return CCC Component; S&P = S&P 500 Total Return Index, S&P Euro 350 = S&P Euro 350 Index: Total Gross Return; REIT = Dow Jones Equity REIT Total Return Index; GSCI = S&P GSCI (Commodities) Total Return IndexTrend line fitted by the equation Y=ax+bx2+c to the data represented by green diamonds. Straight line between single-B and CCC HY bonds

Risk/Return Comparison 2000-2016

15

US MBSTIPS

BB

CS LL Index

US CMBS

EMBI

B

S&P Euro 350

CCCS&P Industrial

MSCI Japan

S&P Energy

REIT

MSCI EM

GSCI

CS Leveraged Equity

S&P FinancialS&P Tech

PE

1-3 Month T-Bill

Barclays Agg.UST 7-10 Yr

HY

S&P 500

-2%

0%

2%

4%

6%

8%

10%

12%

14%

0% 5% 10% 15% 20% 25% 30%

Annu

aliz

ed R

etur

n

Annualized Standard Deviation of Returns

S&P Historical Bull And Bear Market Returns 1932-2008

Source: Bloomberg

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