Debt Drives Equities... Especially When Things Get Bad

If you want to be a top-tier equity investor, you need to understand Julis' Law...

Mitch Julis is the co-head of Canyon Capital Advisors, one of the biggest hedge funds in the U.S. He's one of the greatest value investors of all time, up there with legends like Warren Buffett, Seth Klarman, and Howard Marks. He's also one of my most important mentors.

I met Mitch more than 20 years ago. The best advice he ever gave me – what I think of as Julis' Law – is simply this...

To be a successful investor, you need to understand how equity and credit are intertwined.

Canyon invests primarily in debt. So Mitch knows better than almost anyone that a company's debt is a big part of what determines its chance of default... and if it will be able to grow in the future.

Today, we'll take a closer look at Julis' law. And we'll examine what credit is saying about the current state of the economy.

Whether you invest through stocks or bonds, you're buying a claim on a company...

With stocks, you're owning a piece of that company. With bonds, you're getting a piece of the company's debt.

Bonds give you a more senior claim. In the event of a bankruptcy, bondholders get paid back before stockholders... So you have a better chance of getting repaid at all.

That also means it takes more for creditors to be worried about their investments.

Stockholders are concerned with day-to-day share price fluctuations. They have to consider what the overall market is doing... and what it means for their stock positions.

All bondholders care about is whether the company can stay solvent until its bonds mature.

And because of that, credit investors are more risk averse from the start. They're more aware of a company's potential pitfalls before making an investment decision.

All of that means credit experts like Mitch have to be hyperaware of the state of the credit market...

At a presentation earlier this month, Mitch brought up the concept of "covenants over contracts." While he talked a lot about covenants in relationships, he's also always keeping tabs on credit covenants.

A covenant is the part of a credit agreement that helps make sure companies aren't taking on too much risk. Covenants protect the lenders.

Since the end of the Great Recession, lenders have lost almost all of their negotiating power. As interest rates dropped, lenders didn't have as much wiggle room to offer lower rates than other lenders. So they had to start dropping covenants to win debt deals.

In the past five years, a huge number of credit agreements were what's called "covenant lite." As you've probably guessed, that means they have minimal covenants... or none at all.

That makes it easier for borrowers to access credit. It also takes lenders' guardrails away.

Even as interest rates rose through 2022, lenders weren't able to negotiate much stricter covenants. However, that's finally starting to change...

Consumer and corporate defaults are starting to rise. Lenders aren't willing to take on as much risk anymore.

We're finally starting to see a rise in covenant protections on corporate debt deals. It's another sign that the credit market is telling the equity market to watch out.

Regards,

Joel
June 30, 2023