Corporate debt: the big bubble to watch now
Ten years on from Lehman Brothers, where does the biggest risk lie? On corporate balance sheets.
The ten-year anniversary of Lehman Brothers going bust has been the cue for many reflections on what exactly went wrong and what we should or could have done about it. But while this is all very interesting (or not, depending on your point of view), a more pertinent question for investors today is: what will spawn the next big crash? Banks are safer than they were even if they haven't been sufficiently restructured for our liking so it's unlikely to originate with them this time. But as David Rosenberg of Gluskin Sheff notes, you don't need fragile banks to have a market crash the dotcom bust is just one example.
So what do we need to worry about today? Cheap money generally flows somewhere, and Rosenberg is pretty clear on where the bubble now lies: "The corporate bond market is today's bubble, just like the mortgage market a decade ago," he recently told CNBC. There is now roughly $4.3trn-worth of "lower-quality corporate loans and high-yield bonds" out there, which is almost double the quantity eight years ago. Last year, reports The Economist, S&P classed 37% of global companies as "highly indebted", up from 32% in 2007. And a lot of this debt has been cut up and recombined into collateralised loan obligations (CLOs), similar to the mortgage-backed securities at the heart of the last crisis.
Meanwhile, as lending has soared, the quality of loans has fallen. Ten years ago a third of investment-grade bonds had the lowest possible credit rating (BBB). Now it's nearly half. The issuers are also carrying a lot more debt than they once did the "net leverage ratio" is 2.9, up from 1.7 in 2000. Investment-grade issuance is also now much more sensitive to interest-rate changes (in other words, even a small rise in rates will push the price down). At the riskier end of the spectrum, yield-starved investors have been happy to lend with few strings attached (to grant what are known as "covenant-lite" loans) to high-risk firms and to fund buy-out deals.
The good news is that the banks aren't as heavily involved this time around. Instead, the debt is mostly held by "private-equity firms, hedge funds, insurance companies, mutual funds and other financial companies", notes USA Today. Also, problems with corporate debt (which would hurt a limited number of balance sheets) are not as disruptive to the economy as a house-price crash (which affects nearly everybody's balance sheet). However, as borrowing costs rise, we can expect to see more companies run into trouble. As for the wider equity markets, cheap borrowing has been a key source of share buybacks in recent years. If that funding source is removed, that'll take some steam out of equity markets too.
On the tenth anniversary of the Lehman Brothers blow-up, "central-bank arrogance is one of the main reasons we should still be scared", argues Albert Edwards, Societe Generale's famously bearish global strategist. The collapse of the investment bank certainly "caused the financial system to seize up". But the US economy was already in "deep recession" by that point. Yet the key US policymakers at the time of the crisis Federal Reserve chief Ben Bernanke and US Treasury secretaries Hank Paulson and Tim Geithner were oblivious. They "never recognised beforehand that the economy was a massive credit bubble", Edwards says. "Just like it is now."
What should we be watching now? "The most important global economic data point is now undoubtedly US average hourly earnings." Wage inflation is a critical variable when it comes to the speed of central-bank tightening, and US wage inflation now appears to be in a "decisively upwards" trend. In fact, Japan may be leading the way on that front faced with a very tight labour market and historically low unemployment, Japanese annual wage inflation surged above 4% recently. If the US sees a similar move, then year-on-year pay growth could jump from an "already worrisome 2.9%" to 4.5%.
Surveys indicate that global economic growth is decelerating, although that excludes the UK, which after a couple of years of "savage fiscal tightening" is now loosening the reins somewhat, notes Edwards.