NEW YORK – Homeowners appear to have learned the lesson of the Great Recession about not taking on too much debt. There is some concern that Corporate America didn’t get the message.
For much of the past decade, companies have borrowed at super-low interest rates and used the money to buy back stock, acquire other businesses and refinance old debt. The vast majority of companies are paying their bills on time, thanks in large part to profits that have surged since the economy emerged from the Great Recession nine and a half years ago.
But with interest rates rising and U.S. economic growth expected to slow next year, worries are building from Washington to Wall Street that corporate debt is approaching potentially dangerous levels. U.S. corporate debt has grown by nearly two-thirds since 2008 to more than $9 trillion and, along with government debt, has ballooned much faster than other parts of the bond market. Investors are most concerned about companies at the weaker end of the financial-strength scale – those considered most likely to default or to get downgraded to “junk” status should a recession hit.
“I’ve been more worried about the bond market than the equity market,” said Kirk Hartman, global chief investment officer at Wells Fargo Asset Management. “I think at some point, all the leverage in the system is going to rear its ugly head.”
Consider General Electric, which said in early October it would record a big charge related to its struggling power unit, one that ended up totaling $22 billion. Both Moody’s and Standard & Poor’s subsequently downgraded GE’s credit rating to three notches above “speculative” grade, which indicates a higher risk of default.
GE, with about $115 billion in total borrowings, is part of a growing group of companies concentrated at the lower end of investment-grade. Other high-profile names in this area within a few notches of junk grade include General Motors and Verizon Communications. They make up nearly 45 percent of the Bloomberg Barclays Credit index, more than quadruple their proportion during the early 1970s.
Credit-rating agencies say downgrades for GE, GM or Verizon aren’t imminent. But the concern for them, and broadly for this swelling group of businesses, is if profits start falling or the economy hits a recession.
If those companies do drop below investment grade, they’d be what investors call “fallen angels,” and they can trigger waves of selling. Many mutual funds and other investors are required to own only high-quality, investment-grade bonds – so they would have to sell any bonds that get cut to junk.
The forced selling would lead to a drop in bond prices, which could result in higher borrowing costs for companies, which hurts their ability to repay their debts, which could lead to even more selling.
Even the chairman of the Federal Reserve has taken notice of the rise in corporate debt. Jerome Powell said in a recent speech that business borrowing usually rises when the economy is growing. But he said it’s concerning that, over the last year, the companies increasing their borrowing the most are those already with high debt and interest burdens.
To be sure, many bond fund managers say companies were smart to borrow hefty sums at low rates. And at the moment, there are no outward signs of danger. The default rate for junk-rated corporate bonds was 2.6 percent last month, which is lower than the historical average, and S&P Global Fixed Income Research expects it to fall in upcoming months.
Even if the economy does fall into a recession, fund managers say losses won’t be to the same scale as 2008 when the financial crisis sent the S&P 500 to a drop of nearly 37 percent and the most popular category of bond funds to an average loss of 4.7 percent.
In his speech, Powell said he doesn’t see the weaker parts of the corporate debt market undermining the financial system in the event of an economic downturn, at least “for now.”
Other investors see the market’s growing worries as premature. Companies are still making record profits, which allow them to repay their debts, and consumer confidence is still high.
“There is a story out there that there’s a recession coming very soon, and you had better head for the hills,” said Warren Pierson, deputy chief investment officer at Baird Advisors. “We think that’s a pretty early call. We don’t see recession on the horizon.”
That’s why he and Mary Ellen Stanek, who run bond mutual funds at Baird, haven’t given up on corporate bonds, even if they’ve moderated how much they own.
But critics see some echoes of the financial crisis in today’s loosening lending standards. Consider leveraged loans, a section of the market that makes loans to companies with lots of debt or relatively weak finances. These loans have been popular with investors in recent years because they often have what are called floating rates, so they pay more in interest when rates are rising.
Paul Massaro, portfolio manager for floating-rate strategies at T. Rowe Price, says he’s still positive about this market in general. But his team of analysts has been finding more warning flags in offerings, where the terms of the deal may be overly friendly to borrowers and allow them to amass more debt than they should.
It’s gotten to the point where Massaro is participating in about 15 percent of all offerings today, down from 30 percent a few years ago.
Investors have largely been willing to stomach higher risk because they’ve been starved for income following years of very low interest rates.
As a result, some bonds that by many accounts look like risky junk bonds are trading at prices and yields that should be reserved for higher-quality bonds, say Tom McCauley and Yoav Sharon, who run the $976.3 million Driehaus Active Income fund. To take advantage, they’re increasingly “shorting” corporate bonds, which are trades that pay off if the bonds’ prices fall.
They recently began shorting bonds of a packaged goods company with a “BBB” rating that borrowed to help pay for a large acquisition, for example. A “BBB” rating is at the lower end of investment grade, and a drop to “BB” would send it into junk status.
With so much debt, McCauley and Sharon believe that it’s at risk of getting downgraded to junk and is not paying enough in yield to compensate for its risk.
“As we get into the later stages of the cycle, the sins of the early stages of the cycle tend to start showing up,” said Sharon. “We think that’s where we are today.”
Subscribe to the Coronavirus newsletter
Get the day’s latest Coronavirus news delivered to your inbox by subscribing to our newsletter.