“When credit starts looking dicey, investors quickly pay attention and for good reason,” says Michael Mackenzie in the Financial Times. In 2008, US subprime mortgage loans triggered the financial crisis. Now, eyes are turning to record high corporate debt, with investors fearful that we are heading into a “typical late-cycle period where the excesses of corporate borrowing come home to roost”. Already, 2018 is proving to be the worst year for investors in both investment-grade and high-yield (“junk”) debt since 2008, with total returns negative for the year.
Since the financial crisis, non-financial annual corporate bond issuance has risen by 2.5 times, from $800bn in 2007 to $2trn in 2017. The value of outstanding corporate bonds has nearly tripled over the same period, to $11.7trn, notes the McKinsey Global Institute. At the same time, the quality of credit has deteriorated. The global high-yield market is now worth $1.9trn, almost quadrupling in size in a decade, while there has been “explosive growth of lower-rated investment-grade paper”, notes Mackenzie – it now accounts for about half of all outstanding US and European investment-grade corporate bonds, from a third in 2008. “Issuers are also more heavily indebted than before.”
A borrowing binge
Companies have gone on a borrowing binge against a backdrop of low interest rates, quantitative easing (QE) and the corresponding surge in investors’ desperation for sources of yield income. Yet with QE being stopped or reversed in most parts of the world, and the Federal Reserve raising interest rates, the risk now is that lending and borrowing decisions made during the good times will look rather less sustainable against a harsher economic backdrop, particularly as a record amount of high-yield debt looks set to need refinancing in the next few years.
McKinsey reckons 20%-25% of corporate bonds in Brazil, China, and India are already at higher risk of default. A two-percentage point rise in interest rates could push that to 30%-40%. In advanced economies, fewer than 10% of bonds are from firms with weak finances, but in the US 18% of the value of energy-sector debt is at higher risk of default.
Also of concern are “leveraged loans”, of which there are $1.3trn outstanding, reports the International Monetary Fund (IMF). Many of these loans – typically taken on by already heavily indebted companies – are “covenant-lite”, which means the lender has less protection from default. In 2007, “cov-lite” loans accounted for about 25% of leveraged loans – now it’s a record 80%. What’s more, about half of these loans have been sold to private investors.
“Given the increase in leveraged loans and bonds that are close to junk, the analogy to subprime seems a little too close for comfort,” says Noah Smith on Bloomberg. The downturn might still be a while off, so it’s not time to panic. But if left unchecked, this “build-up of risk” in the corporate bond market “could be big trouble”. When the next recession strikes, corporate debt is likely to make it worse.