The Corporate Debt Bubble Continues to Grow

The Corporate Debt Bubble Continues to Grow

Stocks aren’t the only thing breaking record highs. The recordhigh corporate debt bubble that looms over the stock market, and economy, continues to grow.

But should that worry you? Several analysts are saying yes it should, citing similarities to the subprime mortgage crisis of 2008.

How much corporate debt is there?

According to S&P Global, the dollar amount of corporate debt is roughly $9.3 trillion as of January 1st, 2019. That’s more than 45% of the U.S. annual GDP.

What’s most alarming is the rising amount of leveraged loans. These types of loans are given to companies that are already drowning in debt or have a very poor credit rating. The U.S leveraged loan market hit the $1 trillion mark back in April of 2018 and continues to grow. We are looking at an increase of over 100% since 2007.

Leveraged Loans Outstanding
Source: Bloomberg

How did we get here?

The main cause of the record-breaking corporate debt bubble is historically low-interest rates. The Federal Reserve made drastic cuts to interest rates and pumped trillions of dollars into the financial system through quantitative easing. This was done to help the economy recover from the Great Recession of 2008.

The quantitative easing (QE) programs involved the Fed creating money digitally and using it to buy bonds. QE helped support the bond market and resulted in super-low bond yields. Low bond yields encouraged businesses to borrow. Companies have since been gobbling up cheap debt and using it for somewhat questionable reasons, like stock buybacks.

Some corporations have been using debt for stock buyback programs and other financial engineering tactics to increase share prices. When a company buys its own stock at high valuations, it can increase its vulnerability during a recession.

Despite some of the controversial uses of capital, the stimulus worked in terms of increasing growth and aiding in the economic recovery. Earlier this month, the U.S. economy reached the longest expansion in its history. Debt, low-interest rates, and quantitative easing have boosted the prices of stocks, bonds, real estate, and other assets. It’s a big part of why the market has been performing so well.

How is it similar to the subprime mortgage bubble?

Back before 2008, it was a common belief that U.S. house prices will never go down. That belief ended up backfiring once the subprime mortgage crisis hit.

To quickly summarize the main cause of the crash, subprime mortgages were packaged into collateralized debt obligations known as CDOs. Somehow these high-risk CDOs were given high ratings, and once borrowers started to default on their mortgages, their value plummeted.

Now we have high-yield ETFs that are packed full of junk bonds and other subpar securities. While the risks are more known than the CDOs issued over 10 years ago, the promised liquidity may not actually be there. Once a downturn hits, will enough market makers be willing to purchase and absorb all the selling? Most likely not.

The increased yield of these ETFs pay investors that are willing to accept the lack of liquidity and less than favorable underlying bonds. But how many retail investors understand all the risks?

The amount of low-quality corporate debt is reaching alarming levels, just like the subprime mortgage debt in 2008. BBB-rated bonds are the lowest rated bond that can still pass as investment grade. And according to Morgan Stanley, the U.S. is getting flooded with BBB-rated bonds.

Below shows the increase of BBB rated corporate bonds from January 1995 – January 1st, 2019.

The Corporate Debt Bubble Continues to Grow
Source: Bloomberg Barclays Indices

Worst case scenario

The Federal Reserve began increasing interest rates for the first time since the recession near the end of 2015. In 2018 the Fed began unwinding its balance sheet in an attempt to reverse Quantitative Easing (QE), known as Quantitative Tightening (QT).

Along with QT, the Fed began to increase interest rates a bit more aggressively through 2017 to December of 2018. This was done to normalize interest rates (they can’t be historically low forever right?) and help decrease inflation.

The Fed was on track to continue rate increases throughout 2019 until the stock market had a pretty drastic dive in the fourth quarter of 2018. The market was not happy with the mix of increasing rates and record-high debt levels. Higher interest rates make it harder for companies to refinance and meet payment obligations.

While interest rates only increased by 2.25% (over a period of 10 years, since the recession). The Fed changed course and has stopped increasing rates. Now they are expected to cut rates at the end of this month, in fact, it’s already priced in the market.

The worst-case scenario is a bursting corporate debt bubble that would force a mass of companies to file bankruptcy. The unemployment rate would skyrocket causing the economy to crumble. The fourth quarter of 2018 was just a tiny taste of how bad things could get for the market.

Best case scenario

While corporate debt and subprime corporate debt is getting uncomfortably high, bankruptcies hit a 10-year low at the start of 2019. This is a good sign. The music will continue to play if companies can properly manage their debt.

A lot of investors are looking at the Fed to see how they deal with the consequences created from their Quantitative Easing programs. They are expected to start cutting rates, which some argue is not the right thing to do. Others are in favor of rate cuts, and it may be necessary at least until debt levels decrease.

The best-case scenario would be corporations keeping their debt manageable and properly strengthening themselves to prepare for a recession. This would stop the next downturn from turning into a financial meltdown.

The U.S. stock market has shrugged off a lot of troublesome data and fears of trade wars. Currently Mr. Market doesn’t seem to be bothered by the debt levels, mainly because of the expectation of rate cuts.

Should you be worried?

This article was not intended to spread any fear, gloom or doom bs that you’ll find on some media outlets. The point of the article is to take a hard look at the record levels of corporate debt in the United States. It’s easily ignored when things start to get euphoric.

Corporate debt isn’t the boogeyman, and you shouldn’t start doomsday prepping just because it’s high. Don’t be worried, but maybe be a bit more cautious.