Minsky's Borrower Schema
Hyman Minsky proposed what he called The Financial Instability Hypothesis. The basic idea is that in capitalist economies, periods of stablity (due to conservative lending) lead to instability (due to increased risk taking). Lending becomes lax resulting in debt-induced bubbles which ultimately collapse as the riskier borrowers will default on their loans.
While the theory itself is interesting, I want to just look at his borrower schema. I think it's an insightful way to think about corporate borrowers for investment purposes.
Minsky identified three types of borrowers: hedge borrowers, speculative borrowers and ponzi borrowers.
Hedge borrowers are borrowers capable of making both interest and principal on a loan. A typical example is someone who has sufficient income to make a standard 30 year mortgage.
To give an example, suppose that company XYZ issues bonds to raise $100 and agree to pay 5% coupons for 10 years and then repay the principal after 10 years. XYZ would then need to have at least $15 ($5 interest + $100/10 years principal) in annual cash flows to be classified as a hedge borrower.
Speculative borrowers are capable of making interest payments but do not have sufficient cash flows to make principal payment. So when their debt is due, they will have to refinance the loan or will have to raise capital by some other means (e.g. issue equity, liquidate assets, etc). This puts them at additional risk because their ability to make loan payments depends upon whether or not they can obtain financing from banks or capital markets.
A good example of a speculative borrower is a sound bank. Banking, by its nature, is speculative. Demand deposits are effectively loans that are contnuously being rolled over. But much of the banks' assets are illiquid (in the form of longer term loans to businesses and homeowners they may not be due for 5-30 years). These risks, of course, are somewhat mitigated by having a "lender of last resort".
Ponzi borrowers do not have sufficient cash flows to make either interest or principal payments. They require not only the ability to refinance but also their assets need to appreciate in value sufficiently to make both interest and principal payments.
There were many instances of ponzi borrowers during the housing bubble. When housing prices failed to sufficiently appreciate, the ponzi borrower had no choice but to default.
In many cases, investors borrowing on margin are ponzi borrowers (at the very least, they are speculative borrowers). If income from interest and dividends are not sufficient to pay margin interest, then the borrower ultimately depends upon asset appreciation to offset the interest charges. And since margin loans can be called upon at broker discretion, they are minimally speculative.
For conservative investment, we ought to focus on those enterprises that are using leverage conservatively. The emphasis should then be placed on investing in hedge borrowers. While speculative borrowers may not be bad investments, it should be acknowledged that they present additional risks since they will depend upon favorable refinancing conditions (which may or may not be present.)