During an economic expansion, companies grow and, in order to fuel that growth, they often take on debt. Thus, that corporate debt has risen substantially in the years following the Great Recession should surprise no one.
However, during the current economic expansion, corporate debt has both increased in quantity to an unprecedented scale, and deteriorated in overall quality to a worrying level.
With corporate leverage surpassing past pre-recession levels, investors should be asking serious questions about the sustainability of the current state of play. Additionally, they should cast an eye toward a major driver of the massive re-leveraging: the Federal Reserve’s unprecedentedly loose monetary policy.
Just keep easing
The Fed’s policy of quantitative easing in response to the challenges of the Great Recession resulted in a massive expansion of the central bank’s balance sheet. Over three tranches of QE between 2008 and 2015, the Fed’s balance sheet grew by a stunning $3.6 trillion.
At the same time, the effective federal funds rate was pushed down virtually to zero. As a consequence, borrowing costs - and corporate bond yields - fell to unprecedented lows.
Lever it up
Unsurprisingly, companies responded to historically low borrowing costs with an orgy of borrowing. This is only rational. When borrowing costs are absurdly low, it makes perfect sense to issue debt. The Fed’s aggressive monetary policy loosening lowered short-term borrowing rates at first (the original goal), but this also served to push down long-term borrowing rates for companies.
Between the first quarter of 2011 and the third quarter of 2018, non-financial corporate debt grew at a rate of 6.3% per quarter. Commercial paper has enjoyed a remarkable Renaissance in the years since the recession, rising by more than 13% per quarter (as a part of liabilities), while corporate bonds grew by a still impressive 6.7% per quarter.
Hiding behind the equity
Rising leverage has been hidden in part by an even more extreme rise in equity values. Amazingly, the debt-equity ratios of non-financial corporations fell 12.4% between 2010 and 2017, despite rather massive re-leveraging on an ongoing basis over that period.
How can this be? Well, the answer is quite simple: While debt was rising at a swift clip, a compound annual growth rate (CAGR) of 5.9%, it could not match the 10.3% CAGR enjoyed by the equity market. In other words, the long and powerful bull market has effectively masked the scope of re-leveraging that has occurred over the past decade. As a consequence, conventional measures designed to measure the health of companies based on their leverage, such as the debt-to-equity ratio, have been rendered somewhat useless.
Rising debt, but decling quality
Even as the level of corporate debt has risen, its quality has experienced a marked decline. In fact, the quality of debt is worse than it was during the prior two expansions, according to both Moody’s and Standard & Poor’s. The expansions of 1992 to 2000 and 2002 to 2007, saw investment-grade bonds make up 91.2% and 90.4% of total debt issuance, respectively. Between 2010 and 2018, the rate has been less than 80%.
Worse still, there has been a preponderance of issuances during the current expansion of issuances at the lowest levels of invest-grade quality. In other words, this expansion has seen an unprecedented level of junk bond issuance, while even the investment-grade issuances have skewed by and large toward lower quality.
Verdict
If investors are not worried already, they definitely should be. Economic expansions are invariably accompanied by balance sheet expansions. Companies want to grow and expansions are when they invest. It is a no-brainer to tap into cheap borrowing and growth capital. The long period of staggeringly cheap borrowing experienced during the current expansion has only exacerbated this natural tendency.
Unfortunately, all good things must come to an end. The Fed may be wavering on interest rate tightening, but the notion that the current bull market can last forever is pure fantasy. Every sustained bull market seems to result in commentators and investors buying into the notion that “this time might be different” somehow. Unfortunately, such notions, while seductive, are inevitably proven false by correction and retrenchment.
Investors should be prepared for the market ahead. High leverage and low-quality debt could make the next era of retrenchment particularly painful.
Disclosure: No positions.
