Economies follow cycles. Unlike changing seasons or ocean tides, the timing of a business cycle is never easy to predict. The global economic expansion has gone on for so long that people are wondering if the temporal peak is near, while speculating about the cause for the next decline. While one suspect – the rise in corporate debt – has been garnering more and more attention, we believe the bond bubble is one of the main reasons why the stock market has been pushing new highs and may cause its reversal.
The Rise of Corporate Debt
Following the 2008 financial crisis, the world’s biggest central banks cut interest rates to record lows, providing substantial liquidity to the global financial system via quantitative easing programs. The easy money policies erased yields across a wide swath of debt securities, including government bonds. Contributing to the shift to capital market debt financing, commercial bank lending was also hampered by regulatory constraints and stricter guidelines. The business sector filled the void by issuing bonds as a source of financing for organic and inorganic growth. These securities were then quickly absorbed by yield-seeking investors. Today, nearly 20 percent of total global corporate debt is in the form of bonds, nearly double the share in 2007. Annual nonfinancial corporate bond issuance has increased 2.5 times, from $800 billion in 2007 to $2 trillion in 20171 . And over the last decade, nonfinancial corporate bonds outstanding have nearly tripled to $11.7 trillion, doubling as a share of global GDP2.
Global Corporate Bond Markets Have Expanded
Traditionally, the corporate bond market has been centered in the United States, but now companies from around the world have joined in. This broad shift to bond financing is a welcome development that could contribute to the overall health of the financial system as well as economic growth. However, as with any capital market, there are pockets of vulnerability.
A Significant Share of Corporate Bonds Outstanding is from Issuers Associated with Higher Risks
In the United States, debt issued by nonfinancial companies is near its highest levels as a share of the economy, since World War II3 . Additionally, statistics reveal many higher risk borrowers have benefitted from years of ultra -cheap credit. An increasing amount of funds have been flowing to borrowers that fall within the lowest category of the investment grade ladder known as BBB. This particular category now comprises nearly 40% of the debt currently outstanding and is the single largest piece of the investment grade corporate bond market4. A wave of downgrades from this category would push the bonds across the divide to “junk” status triggering a sell-off. Meanwhile, instead of making the long-term business investments and expansions that were typical in the past, we have seen an increase in the number of corporations using the proceeds of their borrowing to boost their stock prices via share buybacks, dividends as well as mergers and acquisitions. The low interest rate environment and debt fueled capital allocation has helped the S&P 500 rise by over 300% from its Great Recession lows and more than 85% from its 2007 peak.
Another potential source of exposure is soaring corporate debt in developing countries, which has accounted for two-thirds of overall corporate debt growth since 20075 . These bonds typically have higher risk associated with them due to greater political uncertainty, often weaker governance and management, and less transparency on corporate financial performance. The amount of financing issued in foreign currency adds another layer of risk for companies within developing economies. If the local exchange rate depreciates and the company’s revenue is in local currency, the cost of servicing foreign currency debt rises.
Record Refinancing Comes at a Time of Increased Vulnerability Due To Contractionary Monetary Policy
Over the next five years, a total of $7.9 trillion in corporate debt will come due6; meanwhile future financing costs are on the rise making it more expensive for companies to borrow and invest. Corporate defaults are already above the 30 year average7, and likely to move higher as more bonds mature, particularly among speculative grade issuers and some companies in developing countries. And if the recent stimulus of tax reform turbo charges the growth further, it does so at a price that will be paid afterward. Just as loose monetary conditions created the corporate debt bubble in the first place, tightening monetary conditions, including rising interest rates, will likely cause the bubble to burst. While this may not have significant effects on the economy at large, it will have an outsized impact on capital and equity markets.
Navigating the Risks Ahead
Against the backdrop of elevated corporate leverage and tightening financial conditions, we continue to remain cautiously optimistic. The silver lining of having an investment team that experienced the worst financial crisis since the Great Depression is that we have worked to ensure companies within our portfolios are financially stronger and better than before. As bottom up stock pickers, we work overtime to find differentiated companies with sturdy balance sheets, strong cash flows, distinct brands, high quality products or services and significant barriers to entry that will help them survive economic turbulence no matter where we are in the business cycle. After a tough 2008, we are more skeptical, more vigilant and more idealistic. When the markets and economy inevitably do turn, it will be, like all change, an opportunity…
- McKinsey Global Institute. (June 2018). Rising Corporate Debt Peril or Promise? Washington, D.C., pg i.
- Mckinsey. Rising Corporate Debt Peril or Promise? pg i.
- Matt Phillips and Karl Russell, “The Next Financial Calamity Is Coming. Here’s What to Watch.” The New York Times, September 12, 2018, https://www.nytimes.com/interactive/2018/09/12/business/the-next-recession-financial-crisis.html. (accessed September 29, 2018).
- McKinsey. Rising Corporate Debt Peril or Promise? pg 9.
- Susan Lund, “Are We in a Corporate Debt Bubble?” Project Syndicate, June 19, 2018 https://www.project-syndicate.org/commentary/growing-corporate-debt-crisis-risks-by-susan-lund-2018-06?barrier=accesspaylog (accessed September 29, 2018).
- McKinsey. Rising Corporate Debt Peril or Promise? pg 13.
- Lund, “Are We in a Corporate Debt Bubble?”
This commentary candidly discusses current market conditions. The conditions and our opinions are current as of the date of this commentary but are subject to change.
