One of the most-often-cited risks these days – to the market, or to the US economy – is the high level and poor rating of corporate debt. Only recently, the Wall Street Journal reported on a study by the US Federal Reserve that cited concerns over risky corporate debt as “a top vulnerability facing the US financial system”. Many analysts have pointed out that half of investment-grade bonds are only one step away from a junk rating.
Both observations are certainly true. The market value of the corporate investment-grade slice of the Bloomberg Barclays US Aggregate index has risen to nearly 25% of GDP from just 10% before the global financial crisis (GFC). The share of the IG index rated BBB has risen from just 5% in 1973 to 50% today.
Exhibit 1: US corporate debt
Source: Bloomberg Barclays
Are the metrics overstating the risk?
With the development of corporate bond markets over the years, companies have increasingly relied on bonds instead of loans to finance themselves, hence the amount of IG debt rising steadly through to the GFC. As a result of the low interest rates following quantitative easing (QE), debt issuance has doubled relative to GDP over the decade after the GFC.
Japan has seen a similar phenomenon, with government debt rising from 50% of GDP in 1990 to 200% today, alongside the decline in JGB yields. If corporate debt is particularly high today, it is at least partly the result of central bank policy and it is one of the main challenges that the leading central banks face as they attempt to “normalise” the level of interest rates.
The share of BBB debt has been rising for much longer, with no change in the pace after the GFC. Corporate treasurers have evidently determined over the years that issuing lower quality debt is their preferred way of raising debt financing. The stock market has not evidently suffered because of it.
Even if the level of corporate debt is generally high, and its rating low, as long as interest rates remain depressed and the economy is expanding, this debt should not pose a risk to corporate profits. That is to say, when the economy does move into recession, more indebted companies will likely underperform the less indebted ones, as they typically have. But it is not our view that the level of debt itself will precipitate a recession, and we do not see interest rates rising to pre-GFC levels anytime soon.
Debt-to-equity and coverage ratios paint a brighter picture
Moreover, debt-to-GDP ratios likely exaggerate the level of corporate indebtedness. Comparing debt levels to shareholder equity instead of GDP, the corporate debt burden is actually no more than average. Using the Fed’s flow of funds data (now known as the Financial Accounts of the United States), which covers the whole economy back to 1970, we can see that the real peak in indebtedness was back in 1993.
Exhibit 2: Total liabilities to shareholder equity
Note: Non-financial corporate business; data through Q4 2018; source: US Federal Reserve
Additionally, low interest rates mean servicing that debt is much easier. The weighted average coupon of the Bloomberg Barclays investment-grade and high-yield indices has fallen from more than 10% in 1989 to just 4.7% today, so interest expense has not risen by anywhere near as much as the level of debt. Meanwhile profit growth has been quite strong, with the result that coverage ratios are still high compared to pre-GFC levels, though they have admittedly fallen over the last few years.
Exhibit 3: Coverage ratios
Note: Non-financial corporate business. Values for Q2 and Q3 2018 interpolated to smooth Tax Cut and Jobs Act impact. Cash flow defined as the sum of total internal funds, net dividend payments, and the inventory valuation adjustment. Interest expense includes both bonds and loans. Data through Q4 2018; source: Bloomberg Barclays, US Federal Reserve
One day, indebtedness will become a more significant issue for the markets, but thanks to QE, that day is likely to be further off in the future than many now believe.