Shrinking labor dynamics and credit quality: AAA versus Sprint
Available labor: An unprecedented decline
The below graph reflects the same data as the prior graph, though as a growth rate in percent of total workers since 1970. As the U.S. population has grown, and both Baby Boomers and women have entered the workforce since 1970, we’ve seen extraordinary growth in the U.S. labor pool. This bubble in the labor pool was just beginning to deflate in 2008 as the oldest of the Baby Boomer generation, born in 1946, just began to retire. As we look forward, the Baby Boomer exodus from the workforce continues, and as we pointed out in the first graph in this series, the U.S. population growth rate has declined to 0.70% per year—less than half of the nearly 1.70% population growth rate associated with the Baby Boomer generation. This article considers the labor market dynamics associated with the shrinking number of available workforce and the implications for fixed income investors.
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For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Available versus unavailable workers
The yellow line in the above graph represents the “unavailable” workers in the U.S. workforce, which continues to grow as the Baby Boomer generation continues to retire from the workforce. The black line above reflects the percentile change in the number of “available” workers, which is declining in sync with the slowing growth rate of the U.S. population. The blue line reflects the total number of people in the workforce and the associated rate of growth. The blue line shows that the post-1970 growth rate in the U.S. labor force has run its course and has assumed a lower rate, as the bubble of Baby Boomers leaves the workforce, and as the U.S. population growth rate continues to decline.
As we discussed in a prior article in this series, it’s possible that the post-2008 decline in the available workforce was exacerbated by the economic crisis. It’s possible that as many as 1,000,000 Baby Boomers opted for early retirement in the face of poor employment prospects—and the growth of discouraged workers from the 200,000 level to the current 500,000 level also added additional pressure on the post-2008 decline in the available workforce and total workforce. Overall, it should be clear that the yellow line is the mirror image of the black line: as unavailable workers grow in number, available workers shrink. This is a new demographic shift that deserves close attention.
Implications of slow population growth
Overall, the shrinking labor force paints a mixed picture. While a shrinking labor force might lead to a lower unemployment rate in the U.S., the bubble of Baby Boomers living off of retirement could also lead to lower levels of consumption, as many will be living off of lower levels of fixed income during retirement. Unless retirees have been lucky or are lucky with equity investments in the future, retirement funds invested in low-yielding fixed income securities may not provide much to support historical levels of consumption for this portion of the population, which has been a very strong driver of consumption growth in the past. Investors will need to carefully monitor the role consumption has played in sustaining U.S. economic growth. Should the Baby Boomer generation significantly decrease their levels of consumption as they move in to retirement, and the younger generation lacks the purchasing power to fill the gap, we can expect real GDP growth rates to continue to slow. This would be problematic for equity investors, though it would continue to support fixed income markets, which have remained strong, with low yields and fairly tight credit spreads post-2009.
AAA and AA versus below–investment-grade Sprint
Sprint (S) has a market capitalization of $36.17 billion (the value of all its equities), and it’s considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $33 billion of debt by the $7.47 billion of cash holdings leaves approximately $25.5 billion of net debt, and a 1.29 debt-to-equity ratio. However, given the last quarter profit margin of -8.50%, the firm has seen a negative 18.48% return on equity. Sprint is a large company with $35.49 billion in sales revenue, and it still has $5.47 billion in earnings before interest and taxes (EBITDA) to service its net debt of $25.5 billion.
This is sufficient debt service capability, though a weakening economic environment in the USA could compromise the debt service ability in the future. With $48.57 billion in EBITDA and $42 billion in net debt, Verizon is clearly in a much stronger financial position than Sprint. Unless we see labor and productivity increases in the future, companies with weaker earnings margins like Sprint could face further pressures on their bond prices and higher yields. However, the 2013 Softbank merger or acquisition and capital infusion of $5 billion may also improve Sprint’s credit outlook and operating health going forward. While Sprint is in fairly stable condition, it’s not as strong as its competitor, Verizon (VZ), with relatively lower debt levels and more cash on its balance sheet. Sprint currently has an August 15, 2007, senior unsecured bond yielding 2.95%, versus Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile (TMUS) US’s February 19, 2019, senior unsecured bond yielding 3.00%, CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00% (Bloomberg & Capital IQ, December 31, 2013 Quarter).
To see the dramatic growth in the rate that unavailable labor exceeds the rate of available labor into the year 2022, please see the next article in this series.
To learn more about the duration of the fixed income ETFs noted below, please see the related Market Realist series A bond investor’s guide to duration by Surbhi Jain.
Outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)
For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines, should interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current 10 Year Treasury Bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.
However, it should be noted that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA-A rated bonds. In comparison to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 & JNK 4.20), though is very much concentrated in government and high quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.
Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK) offers a similar duration of 4.20 Years versus HYG 3.98 years, holding 84.17% of its portfolio in Corporate Industrial, 7.65% in Corporate Utility, and 7.5% in Corporate Finance-oriented bonds. Like JNK, HYG is also a big fan of Sprint Corp, (S) (0.62%), and First Data Corp. (0.44%), and also holds CIT Group, CIT (0.26%),Caesars Entertainment, CZR (0.24%), T-Mobile USA, TMUS (0.24%), and Tenet Healthcare, THC (0.24%), Ally Financial, ALLY, (0.23%), and SLM Corporation, SLM, (0.22%).
Equity outlook: Cautious
Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Plus, even the global blue chip shares in the S&P 500 (SPY) or Dow Jones (DIA) could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the budget and federal debt issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores (WMT).
Without sustained improvement in economic growth data, there’s little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.
Equity outlook: Constructive
However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 (SPY) price-to-earnings ratio standing at 19.65 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that is “on strike,” including corporate profits, into long-term fixed investments. This could lead to greater economic growth rates and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).