Will Corporate Debt Sink Us?
For more than a year, articles discussing business and corporate debt have captured my attention with increasing regularity. With the Fed’s recent statement that corporate debt is a concern, but not yet a catastrophe, I decided to take a closer look at what these articles are actually trying to tell us about the economy. Below are the questions I wanted to answer and what I gleaned from the authors of these articles (see list of references at the end of this post):
What kind of debt is it?
Generally, non-financial corporate and business debt refers to all interest-bearing borrowings (e.g., bank loans, bonds, etc.) for companies outside of the financial services, banking, and related industries. This includes loans and bonds but does not include asset backed debt like mortgages.
How much debt are we talking about?
There is ~$15trn of non-financial industry debt outstanding, this equates to ~46% of total US Gross Domestic Product (GDP).
Corporate debt as a percent of GDP has increased from a low of ~40% in 2010 after peaking in 2008 at about 45%.
About two-thirds, or $10trn of this debt is corporate debt held by publicly traded firms.
~60% of the $10trn, or ~$6trn of the corporate debt is in the form of bonds, ~75% of which are investment grade, and 25% are high-yield or “junk bonds”.
The remaining 40% of the $10trn of corporate debt are loans, of which ~25%, ~$1.2trn, are “leveraged loans” or loans made to highly indebted companies.
Who’s issuing it and who’s buying it?
Non-financial businesses serve all areas of the economy, but the largest borrowers are in the energy, consumer goods, and industrials sectors.
Bonds are purchased by pension funds, insurance companies, mutual funds and ETFs, households, financial institutions, and even other countries.
Loans are most often issued by financial institutions and commercial banks directly to companies. Some loans are “securitized” and packaged together with other loans and then resold to investors such as insurance companies, pension funds, and private equity (more to come on this topic below).
What are companies doing with the money?
Many are using the money for stock buy backs, dividends, or acquisitions of other firms through take-overs. The Economist states that $2.9trn of equity was retired since 2012, roughly the same as the amount of new debt raised in that time period.
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What are the risks?
There are two main areas of risk: 1) Leveraged loans ($1.5trn) and 2) lower quality bonds including junk bonds ($1.5trn) and lesser quality investment grade bonds ($0.5trn - $1trn). Both leveraged loans and low quality bonds involve over-leveraged companies that are at risk of being unable to service their debt payments in a potential economic downturn if revenues slump or interest rates rise.
If either or both of those circumstances occur, there will likely be credit tightening as rates rise to compensate for risk. This is likely to result in credit downgrades and defaults as more highly-leveraged companies will have a more difficult time covering their debt service. Liquidity could dry up as investors become skittish during events of market stress. These issues could make a recession deeper and longer as companies reduce costs, shed employees, and slow investment as they are forced to de-leverage.
There are some specific leveraged loan-related risks that could result in defaults and credit tightening:
Securitization of the loans (discussed in the next section) can lead to a lack of transparency to the underlying debt, as seen in the financial crisis 10 years ago.
The credit quality of borrowers has decreased because most new loans lack “covenants” that require firms to meet specific financial ratios or risk the lender calling the loan due.
Regulation has decreased as courts have struck down some Dodd-Frank requirements and other regulators’ guidance resulting in a return to more lax lending practices.
Interest rates on leveraged loans are typically floating rates, meaning when rates rise, debt service gets more expensive and could lead to defaults.
There are also some specific bond-related risks that could result in lower liquidity and credit tightening:
Roll-over and replacement of existing bonds is a risk during a downturn or credit tightening event. A majority (>50%) of the outstanding bonds will come due within the next 5 years. It may be difficult to replace these existing bonds with new bonds if interest rates rise, company revenues drop, or liquidity in the market dries up.
The credit quality of bonds issued over the last 10 years has decreased. Today, 40% of all non-financial corporate bonds are BBB-rated, the lowest level of investment grade bonds, up from 22% in 1990. In addition, the high-yield “junk bond” market has seen large growth over the same time period.
Financial ratios such as interest coverage and debt to earnings, which measure the ability to service and repay debt, have deteriorated in the latest recovery, indicating lower credit quality of issuers.
In the event of a downturn or tightening, investors may get jittery in a downturn and sell off bond mutual funds and ETFs, resulting in steep price drops and credit tightening.
Downgrading the credit rating of investment grade corporate bonds could require some investors to dump them due to mandates on quality, also resulting in steep price drops and credit tightening.
How does it compare to the 2008 mortgage backed securities crisis?
Although there are some similarities, it does not look like a repeat of 2008.
CDOs and CLOs, sounds ominous, right?
Leveraged loans are often originated by commercial banks and then “securitized” into Collateralized Loan Obligations (CLOs) and sold to investors.
This should sound familiar, as the process is similar to that used for Collateralized Debt Obligations (CDOs) that were popular 10 years ago before the 2008 recession.
The similarity ends there though, as CLOs are more like actively managed investment funds than the CDOs of the past.
The $1trn dollar 2008 subprime loan market that fed CDOs consisted of mortgages from households where little was known about their incomes and expenses. Those mortgages, thousands of them per CDO, were sliced up and resold in packages to highly-leveraged banks and other private purchasers. Those purchasing the securities did not understand the fundamentals underpinning the mortgages and could not judge their value or riskiness.
The CLO market is smaller, at ~$600+M in value and typically package 100-300 loans per CLO which are sold to institutional investors such as insurers and pension funds.
Much of this debt is issued by publicly traded companies, making it much more transparent. Audited financial statements document the debt and income of these companies and can be monitored in quarterly filings.
Companies’ earnings are very strong today. In aggregate, they have enough earnings to pay the interest on this debt six times over. Although not evenly spread, this should provide enough of a runway to soak up short-term dips in revenues in the event of a downturn.
What should I keep an eye on?
Two causes of souring corporate debt to watch are:
Falling profit margins (this looks more likely, today): Profits are healthy today, but higher wages, tariffs, and other expenses, or a slowing economy could dent profits. All could happen. Inflation caused by tariffs and wage growth could lead the Fed to increase rates just as the economy is slowing and hurting profits. This would lead to credit rating downgrades and investors would begin selling off corporate debt.
Rising interest rates (this looks less likely, today): Even without higher inflation, the Fed could resume raising interest rates to slow the accumulation of debt and the expansion of the economy. Or to prepare for the next recession. That risks causing it, but higher rates will result in higher borrowing costs, higher debt service, and a slower, lower supply of credit.
So, is all this debt a problem at all?
Debt is not necessarily bad. If spent responsibly, it allows companies to expand faster, hire more workers, and invest in new technologies. This should lead to more growth. The key is that the debt is spent sensibly. The concern today is that companies have not spent the money wisely. They have become over-leveraged in a time of low interest rates. And finally, that lower credit quality companies have received much more debt proportionally than the higher credit quality companies. At some point, too much debt becomes a drag on growth as more money is spent to service the debt. The debt load could be too large and cause bankruptcies. Add on the trajectory of the already high-level of US government debt, and “the US economy is much more interest rate sensitive than it has been historically,” wrote Rob Kaplan, President of the Dallas Fed. That could be a very bad thing.
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All statistics, data, and quotes are from the following articles: