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The Debt Reaper
Debt is an integral aspect of modern economies and has long been hailed as a catalyst for growth. When wielded judiciously, it stands as a potent tool for economic development, providing the means to finance projects, expand operations, and invest in essential sectors like education, health, and housing. In the right context, debt fuels economic growth, creates jobs, and fosters innovation. Furthermore, during economic downturns, it offers a safety net for individuals and organizations, helping them weather financial storms.
The ghost of future wealth
Governments have traditionally argued that as long as debt remains manageable and serviceable without difficulty, there’s little cause for concern. While this notion holds some truth, the reality is that recent growth has largely been fueled by an insurmountable increase in debt. Particularly since the Global Financial Crisis of 2008, the creation of what seems like wealth has resulted in soaring asset prices, including equities and real estate, contributing to an alarming rise in wealth inequality. However, there exists a disconnect between perceived wealth and actual wealth, a scenario unlikely to endure. Distinguished economists have persistently argued that debt for consumption essentially borrows demand from the future. This borrowed debt inevitably must be repaid, heralding a probable future slowdown in demand. However, debt allocated for investment purposes differs significantly, capable of fostering future growth and potentially curbing long-term debt.
The trajectory of global debt, as depicted in the chart above, illustrates an unrelenting rise in both government and private debt over time. Up until the 2000s, the surge in debt was primarily attributed to burgeoning private debt, empowering a substantial improvement in living standards, especially in developed nations. Since 2000, private debt has plateaued, whilst government debt has sharply ascended, sustaining the growth in living standards. Yet, the overarching question remains – at what cost? However benign they might seem, debt levels can swiftly move from being a seemingly manageable concern to a formidable challenge once they surpass a particular threshold.
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Defaults in European Retailers and US Energy on the rise
Defaults in European Retailers and US Energy on the rise
2019 has been a pleasant ride so far for high yield investors. Over the past 9 months the global high yield market has delivered a total return of 10.9% and an excess return of 6.4%, in part thanks to the U-turn of major central banks. Despite all the good news, things have occasionally gone wrong.
Recent events have reminded high yield investors that investing doesn’t come without risk. Thomas Cook, the UK tour operator, was grounded after final restructuring negotiations failed. To blame Brexit or the slowdown in global growth for the default would be a hasty conclusion. The business, operating in a structurally challenged industry, had long stretched its financials to the limits. The fragile situation did not go unnoticed by customers, who had stopped booking with the business. As a result of this, 2018 EBITDA (earnings before interest, taxes, depreciation and amortisation) dropped by 14.6% year-on-year which also changed the ability to materially generate positive cash flow. The company produced a negative free cash flow of £148 million in 2018. 2019 half year numbers revealed an even worse picture, with a seasonal outflow of £839 million; £121 million higher than the previous year. Operating with current liabilities that exceeded current assets by £2bn, made the solvency issue even more pressing and, in the end, didn’t allow the company to recover in time. This is a prime example of how quickly things can fall apart if consumers lose trust in a business. With bonds trading currently at 7 cents in the euro, investors only foresee a limited recovery rate for the asset-light business, which is also carrying a large amount of debt structurally senior
to the bonds.
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