The $9 trillion corporate debt bomb is ‘bubbling’ through the US economy

On the face of it, it looks like a $9 trillion ticking time bomb is poised to explode, corporate debt that has grown thanks to easy borrowing terms and a seemingly endless thirst for investors.

On Wall Street, however, hopes are pretty high that this will be a manageable problem, at least for the next year or two.

Resolution is essential for financial markets under fire. Stocks are crashing, credit spreads are exploding, and fears are growing that a combination of higher interest rates on all that debt will start to eat into corporate profit margins significantly.

“There’s angst in the market. It’s not out of place at all,” said Michael Temple, director of credit research at asset manager Amundi Pioneer. “But are we at the point where this thing is exploding like a rocket? I think we’re not there yet. That’s not to say we won’t get there at some point in the next 12 to 18 months. as rates continue to go higher.”

Essentially, the situation can deteriorate in two ways: one good news where companies can manage their debt while the economy stabilizes and interest rates remain under control, and another where the economy slows down, rates keep going up and it’s not so easy anymore. keep rolling that debt.

There’s a worrying trend where companies on the edge of the investment-grade universe are losing their reputations and turning into high-yielding or junk products, sending rates – and defaults – significantly higher. And there is a more positive case where the United States continues to outperform the rest of the world and where corporate debt problems are confined to foreign and specific companies that are not systemically important.

“The answer depends on how long we have until the credit cycle turns, how long we have until interest rates reach the point where they start to stifle activity economic,” Temple said. “If we were of the view that interest rates are already too high for the economy to sustain and that the recession was going to happen next year, then I would say we have a real big problem here.”

As it stands, however, he thinks conditions are still favorable for the business credit market.

“We think economic activity will probably moderate next year, but at a very high level,” he said. “It’s not enough to cause the chaos I just described.”

Over the past decade, companies have taken advantage of low rates to both grow their businesses and reward shareholders.

Total corporate debt rose from nearly $4.9 trillion in 2007 as the Great Recession was just beginning to hit to nearly $9.1 trillion in mid-2018, quietly rising 86%, according to data from the Securities Industry and Financial Markets Association. Apart from a few upheavals and some fairly significant turbulence in the energy sector at the end of 2015 and 2016, the market has behaved well.

In fact, Fitch Ratings expects bond defaults for 2019 to be the lowest since 2013, with leveraged loans the lowest since 2011.

Such high debt levels are “certainly something to consider,” said Eric Rosenthal, senior director of US leveraged finance at Fitch. “In terms of systemic risk, at the moment there is none.”

One of the reasons markets worry about debt is that there isn’t as much cash to cover it. the cash-to-debt ratio for corporate borrowers fell to 12% in 2017, the lowest on record.

Still, there are reasons for optimism.

Fitch estimates investment-grade new issuance was $531 billion in the third quarter, down more than 15% from the same period a year ago. High-yield issuance also fell to $138 billion, down 32% from 2017.

The 2017 tax breaks also appear to be helping. Companies have seen their nominal tax rates drop from 35% to 21% and are apparently using much of the windfall to pay down debt.

Since the tax cut took effect, the top 100 non-financial corporations have spent $72 billion in new cash flow on debt payments, just behind the $81 billion that was spent on shareholder returns through redemptions and dividends, according to Moody’s Investors Service.

“Companies are spending a much higher percentage of additional dollars on debt reduction,” the ratings agency said in a report. “What we see when we look at annual net borrowing activity is a big shift from issuers going from a net borrower each year before the tax review to a net debt payer after the tax review. .”

For issued debt, investor demand remains strong even if it is starting to weaken a little.

A measure of the market’s willingness to acquire bonds, especially those of lower quality, is the quality of covenants or the amount of protections required in the event of default. Moody’s reports that its covenant quality indicator has remained at its lowest rating for 18 consecutive months and is just off the record set in August 2015.

At the same time, it could be a sign of trouble as balance sheet strength becomes more important.

“The high-yield sector, by any measure, just seems pretty overvalued and not worth the level of risk you’re taking,” said George Rusnak, global co-head of fixed income for the Wells Fargo Investment Institute. . “What we’re seeing now is spreads widening, which will have more of an impact on high yield. We could see triple-B credits, some of them, go from investment grade to high performance.”

This shift from low to junk investment quality is one of the things that scares the markets. General Electric is the most publicized case to have this potential, although company officials insist they are doing everything they can to make sure that doesn’t happen.

If such a large company slipped, it would reshape the high yield market. Investors would be counted on to grab these bonds, but they might demand even higher yields to do so.

“It creates a liquidity trap. You get underestimated risk that becomes a catalyst,” Rusnak said. “The second wave of buyers who hold high yield securities are realizing they have more risk than they thought…and it’s kind of a downward spiral.”

Well Fargo itself is exiting the space, with a neutral stance on investment grade companies and an unfavorable outlook on high yield.

“There’s a lot of leverage. You could say they took what the market gave them, to take on the leverage at lower interest rates,” Rusnak said. “The question is whether they will be able to hold on. In many cases they will, but there will be a seething simmer of challenges.”

One of those other challenges also comes from the leveraged loan market, an area of ​​growth that now exceeds high yield in total issuance with $1.3 trillion.

Senator Elizabeth Warren has spoken publicly about the threat at a recent public hearing, the Massachusetts Democrat warned Randal Quarles, the Federal Reserve’s Vice Chairman of Oversight for the Banking Sector, that leveraged lending poses a large-scale economic threat along with subprime lending of ten years ago.

“The Fed dropped the ball before the 2008 crisis by ignoring the risks in the subprime mortgage market,” Warren said.

Simon Macadam, global economist at Capital Economics, also said leveraged loans, which are typically given to lower-quality borrowers who already have substantial debt on their balance sheets, pose a danger.

“The main concern is a drop in lending standards,” Macadam said in a note to clients. “In the United States, the share of leveraged loans without requiring borrowers to meet regular financial tests, such as maximum leverage and minimum interest coverage ratios, fell from about a quarter in 2007 at an all-time high of 80% today.”

However, Macadam said that “at the moment” there are “at least three sources of comfort” as to why the danger will not become systemic: “manageable” corporate debt burdens, stronger bank capital and a expected moderation in interest rate hikes. . Capital has an off-consensus forecast that the Fed will start cutting rates in 2020 as the economy weakens.

Currently, the Fed is expected to approve one rate hike in December and expects three more in 2019.

Indeed, bond strategists who spoke to CNBC were nearly unanimous in their belief that corporate debt issues will be far more company-specific than systemic.

“From an upper level of 30,000 feet, most U.S. companies are in pretty good shape,” said Yvette Klevan, portfolio manager for global fixed income at Lazard Asset Management. “The economy is still very strong. Tax reforms are beneficial. Looking to next year, overall debt service should be very stable and not a problem. We see a lot of opportunities in the market. “

The current climate is likely more conducive to actively managing or picking individual issues, rather than following broad cues, Klevan said. Taxable passive bond funds currently hold over $1 trillion in total assets.

The current climate shows “how important it is to do your homework”, she added. “From my point of view, it is essential to have diversification.”

Lazard has found value in “green bonds,” which focus on companies that invest in environmentally sustainable ways.

That’s not to say there’s no danger there, but Klevan doesn’t see it in a macro sense for the United States.

“We all need to be very mindful of this accumulation of debt everywhere, over the last five to seven years in particular,” she said. “Overall, and I’m saying this probably from a sovereign perspective, debt can be a tax on growth. So that’s going to have a big medium-term impact on a lot of countries.”