PMC Weekly Review - May 18, 2018
A Macro View: A Look at Corporate Credit Writ Large
Earlier this month, the Buttonwood columnist at The Economist speculated that corporate credit may be the trigger for the next financial crisis. He isn’t the first, and for good reason. The worst crises are often fueled by debt, and quantitative easing, in concert with preexisting statutes that favor debt-heavy capital structures, has given corporations an incentive to go on a borrowing binge. Further, the average credit quality of outstanding corporate debt has fallen, whereas the excess yield for owning corporates over Treasurys has fallen. Given the economy’s progression into the later stages of expansion, it is worth further exploring how the investment grade bond market in particular has changed over the last decade.
The absolute size of the corporate bond market is the most notable shift in the post-crisis period. Since 2009, domestic corporate debt outstanding has risen a striking 56% to just under $8.5 trillion, according to the Federal Reserve (Fed). Moody’s Investors Service notes that nonfinancial corporate debt’s share of gross domestic product is more than 45%, the highest it has ever been, and is trending higher. Clearly, the post-crisis environment and its accompanying set of policy responses have stimulated debt issuance, but how much concern should investment grade corporate debt merit? It may not deserve much, at least for now, as it doesn’t appear to represent an immediate threat. Until very recently, debt service as a percentage of corporate income has remained below levels seen in the previous cycle, though this figure is also trending higher as the Fed incrementally removes monetary stimulus and the Treasury ups its debt issuance.
Size isn’t everything, and that maxim holds true in this case as well. As the size of the corporate debt market has grown, its composition with regard to quality and sensitivity to interest rate risk has shifted. In terms of quality, BBB-rated bonds, the lowest rung of the investment grade market, are now the largest component of the Bloomberg Barclays Credit Index (the Index), encompassing roughly half of outstanding investment grade issuance. At the same time, higher-rated bonds have shrunk to ever-smaller proportions, as corporations see little incremental value in maintaining sterling credit credentials. As the Index’s credit quality has fallen, interest rate risk, as measured by average maturity, has surged. Average maturities of all credit-quality tiers within the Index have extended since the financial crisis, with outstanding AAA-rated debt maturity extending from 12 years to nearly 18 years on average. Given these shifts, successful investors have found it increasingly necessary to scrutinize the credit and interest rate risks within their portfolios.
It is entirely possible that the shifts outlined above, especially if they continue on trend, will serve as tinder for a forthcoming economic conflagration. Assuming benchmark borrowing costs continue to rise, debt service will likely eat up an ever-larger portion of corporations’ cash flow. The highest-quality issuers are flush in cash—some even have negative net debt—so refinancing, or even paying down their debt burden outright, should prove relatively painless. However, many more firms will be squeezed as they are forced to refinance at higher rates. Avoiding corporate debt altogether would be imprudent for most investors. But, as the waters get choppier, they would be wise to delegate this portion of their portfolio (and most bond allocations) to active managers, who can manage credit and interest rate exposures, rather than incurring unmitigated exposure to the numerous risks that are accruing in the space.
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