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Corporate bonds: where the next financial crisis will start

The next financial crisis could start in corporate bonds, as credit quality has deteriorated over the past few years and decades.

"The genesis of the next crisis is probably lurking in corporate debt," says Buttonwood in The Economist. Years of extremely low interest rates have prompted an unprecedented worldwide borrowing binge. According to the credit-rating agency S&P Global, last year 37% of global firms were highly indebted (a state defined as having debts worth five times earnings or more). That's 5% more than just before the crisis a decade ago.

Credit quality has also deteriorated over the past few years and decades. The median corporate bond is now rated BBB-, which is one notch above speculative, or junk, debt. In 1980 the median was rated A. Even in the investment-grade category, quality has dwindled. Forty-eight per cent of US corporate bonds are rated BBB, up from a quarter in the 1990s.

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Meanwhile, investors seem so complacent that they are not even demanding higher rates to make up for the falling credit quality; the gap between corporate and government debt in the US and Britain is still extremely small.

Finally, banks have withdrawn from the market-making business in bonds owing to stringent post-crisis regulations, says Buttonwood. So a dearth of liquidity could exacerbate a sell-off. All this means that corporate paper thus looks extremely vulnerable to rising interest rates. "Removing the easy-money punch bowl," says S&P Global's Terry Chan in Barron's, "could trigger the next default cycle."

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