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The US will soon have enjoyed the longest continuous period of economic expansion on record. Given this, it is natural that investors would look for any emerging imbalances in the global economy that could disrupt this long run of economic growth.
For now, the outlook for household debt as a percentage of GDP is relatively benign, with consumer indebtedness having shrunk in both the US and the UK – albeit relatively moderately in the case of the latter.
However, as a corporate bond investor, my interest lies in the trends for corporate debt. One consequence of the financial crisis was greater regulation of banks and insurance companies. The result has been a marked reduction in financial sector debt. But for non-financial corporates, the Bank for International Settlements estimates that debt-to-global GDP has risen from 82% in 2008 to 93% in 2018. This hardly constitutes a bubble and can largely be attributed to the explosive growth of corporate debt in China. However, the Federal Reserve Bank of Dallas recently identified this as a trend worth monitoring, especially as the level of US corporate debt has now surpassed previous peaks.
The increase in corporate debt is reflected in indices that track higher-quality ‘investment grade’ non-financial bonds. From 2006 to 2018, the UK, US and European investment-grade bond markets grew in value by 189%, 280% and 339% respectively. The size of the US market is now $4.7 trillion.
What has driven this dramatic escalation in corporate debt levels? Well, like any market, the corporate bond market requires a meeting of buyers and sellers (or in this case issuers of bonds). This dynamic has been given added impetus by the aftermath of the financial crisis. As interest rate cuts and quantitative easing (QE) have driven government bond yields to historic lows, investor demand for the potentially higher returns of corporate bonds has been, at times, insatiable. Companies have been only too happy to take advantage of these historically low borrowing costs by issuing bonds to investors.
One notable feature has been the growth in the number of bonds with a ‘BBB’ credit rating. This is the lowest credit rating an investment grade-rated bond can have, any lower and it is assigned ‘high yield’ or ‘junk’ status. Ten years ago, BBB rated bonds comprised 15-30% of corporate bond markets in the developed world. Now, they constitute 50%.
Some of this can be attributed to unintentional factors. In sectors such as utilities and telecoms, traditionally large issuers of corporate bonds, we have witnessed a deterioration in credit quality. However, much of the increase in the number of BBB rated bonds has been due to a conscious decision by companies to take advantage of low borrowing costs in order to fund share buy-backs, dividends and, crucially, large-scale acquisitions. The pharmaceutical, telecom, media, tobacco and beverage sectors have all experienced significant levels of merger and acquisition (M&A) activity.
Why should this shift lower in overall credit ratings concern investors? Two reasons. First, as a higher proportion of companies now find themselves heavily indebted, they are choosing to strengthen their balance sheets. This could result in cost-cutting and lower levels of investment. This could, in turn, either slow the economy or, perhaps more seriously, amplify the next downturn. Second, when the next downturn does arrive, a percentage of BBB rated bonds will inevitably be downgraded to high-yield status. Given that US and European investment-grade markets are considerably larger than their respective high-yield markets, it would be surprising if investors were willing to own all such bonds at their lower ratings. A scarcity of buyers could result in a market dislocation, with stressful conditions resulting in the price of a bond not accurately reflecting the fundamental credit worthiness of its issuer.
The Dallas Fed’s conclusion was that the increase in corporate debt levels required vigilance on the part of investors. We share that view. For corporate bond investors, diligent research is crucial in order to avoid companies that are likely to make their way from investment grade into high yield markets in the coming years. Of course, if a market dislocation does occur, this will provide a potentially attractive opportunity to invest in corporate bonds. , especially as it appears increasingly probable that interest rates are set to remain low and the demand for corporate bonds is unlikely to evaporate any time soon.