For some time, many experts, including William (Bill) D. Cohan, a former investment banker and author of several books, including the most recent, Why Wall Street Matters, have been warning us about the dangers of the corporate debt bubble.
Lest we forget, the Federal Reserve had a significant role in dropping interest rates, and thus setting the stage for the financial crisis. In turn, this caused investors to seek debt instruments that paid a higher rate of return, which then led to the explosion of the mortgage-backed securities market. To meet the ever-increasing demand financial companies and their securitizers became very aggressive in making and purchasing mortgages with lesser credit quality.
And so it came as a surprise to me to read a recent article by Robert S. Kaplan, President of the Federal Reserve Bank of Dallas, now talking about corporate debt as a potential amplifier in a slowdown, of which I’ll say more.
As Bill Cohan pointed out in his August 2018 New York Times op-ed, we pay attention to the stock market’s highs and lows; when high, “we instinctively feel things are good and getting better, when it tanks… we think things are going to hell.”
However what struck me was his warning about the domestic corporate debt market, which he said, “…reveals more about our nation’s financial health. And right now, the debt market is broadcasting a dangerous message: Investors, desperate for debt instruments that pay high interest, have been overpaying for riskier and riskier obligations. University endowments, pension funds, mutual funds and hedge funds have been pouring money into the bond market with little concern that bonds can be every bit as dangerous to own as stocks.”
And Cohan sums it up by saying, “… for much of the last decade, risk has been mispriced to a staggering degree.”
So the price of these bonds and loans have not reflected the risk of borrowers credit – that those who are at risk pay a higher cost in interest giving an investor a higher return. Common sense, however since the financial crisis “investors have been paying higher prices for the debt of riskier companies and not getting properly compensated for that risk… investors assume that the good times will never end.”
And the Fed is abetting this again with its low interest rates!
Mr. Kaplan’s essay focused on trends in corporate debt growth and credit quality in the U.S. and the potential implications for economic conditions and financial stability. Mr. Kaplan gave a very thorough history of indebtedness in the U.S; and then took us to the trends he sees in nonfinancial corporate debt.An alarming trend as “most of this debt consists primarily of bonds and loans and nonfinancial corporate bonds outstanding in the U.S. which grew from approximately $2.2 trillion in 2008 to approximately $5.7 trillion at year-end 2018.” But the most disturbing trend is the substantial increases in the total of the non-investment grade and the lowest investment grade of BBB, which totaled $1.5 trillion in 2008, growing to $3.8 trillion in 2018.
This substantial growth in BBB and lower-rated bonds is indicative of a weakening in corporate credit quality in the U.S.
Mr. Kaplan continues, “It is estimated that a substantial portion of the increase in nonfinancial corporate debt was used to fund share buybacks, dividends and merger activity. This trend has been accompanied by more relaxed bond and loan covenants, which have had the effect of reducing protections for investors” something I have sounded the alarm about as well.
Mr. Kaplan obviously agrees with Cohan, saying “In the event of a downturn, highly indebted companies may be more vulnerable to seeing their credit quality deteriorate … with risk of downgrades to less than investment grade.” This would “further negatively impact credit spreads and market access for more highly indebted companies.”
He notes that “vigilance is warranted as these issues have the potential to impact corporate investment and spending plans. In the event of an economic downturn, these issues could also contribute to a deterioration in financial conditions which could, in turn, amplify the severity of a growth slowdown in the U.S. economy.”
The comparisons between the mortgage securitizations market in the last financial crisis and the current nonfinancial corporate bond market are alarming. Robert Ross points out in a recent article in Newsmax Finance that “Since the end of the financial crisis, the triple-B corporate bond market has grown to twice the size of the subprime mortgage market… This market is an accident waiting to happen.”
“Corporate bonds are debt issued by companies. It’s a way for companies to raise money, and the money must be paid back. Almost every company in the world uses the corporate bond market. But just like the subprime mortgage market, it’s the poor quality of the debt that’s the problem. In a recession, BBB-rated bonds are the most vulnerable of all investment-grade bonds.”
Ross says, “According to Moody’s, 10% of BBB-rated corporate bonds become what’s known in the industry as “fallen angels” in a recession. That’s a tactful way of saying they’ve been downgraded to “junk” status.”
From my perspective, we are on the same road again, headed into the next financial crisis. And the Fed is helping this along!