Should The World Worry About America's Corporate-Debt Mountain - Carrying The Weight

18/03/2019 Should the world worry about America’s corporate-debt mountain?
- Carrying the weight
Carrying the weight
Should the world worry about America’s corporate-

debt mountain?
It is not like the subprime crisis. But it could make the next recession worse
Print edition | Briefing

Mar 14th 2019
A merican household debt set o the global nancial crisis in 2007. But for much of
the subsequent recovery America has looked like a paragon of creditworthiness. Its
households have rebuilt their balance-sheets; its rms have made bumper pro ts; and its
government goes on providing the world’s favourite safe assets. If people wanted to look
for dodgy debt over the past decade they had to look elsewhere: to Europe, where the
sovereign debt crisis dragged on; to China, where local governments and state-owned rms
have gorged themselves on credit; and to emerging markets, where dollar-denominated
debts are a perennial source of vulnerability.
https://www.economist.com/briefing/2019/03/16/should-the-world-worry-about-americas-corporate-debt-mountain 1/14
18/03/2019 Should the world worry about America’s corporate-debt mountain? - Carrying the weight
Should they now look again at America? Household debt has been shrinking relative to the
economy ever since it scuppered the nancial system. But since 2012 corporate debt has
been doing the opposite. According to the Federal Reserve the ratio of non- nancial
business debt to gdp has grown by eight percentage points in the past seven years, about
the same amount as household debt has shrunk. It is now at a record high (see chart 1).
This is not bad in itself. The 2010s have been a rosier time for rms than for households;
they can a ord more debt, and a world of low interest rates makes doing so attractive.
Moreover the rms are not borrowing the money for risky investments, as they did when a
craze for railway investments brought about America’s worst ever corporate-debt crisis in
the 1870s. In aggregate they have just given money back to shareholders. Through a
combination of buy-backs and takeovers non- nancial corporations have retired a net
$2.9trn of equity since 2012—roughly the same amount as they have raised in new debt.
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For all that, a heavy load of debt does leave companies fragile, and that can make markets
jittery. In 2018 concerns about over-indebtedness began to show up in nancial markets.
The average junk-bond investor ended the year with less money than they had at the start
of it (see chart 2)—only the second time this had happened since the nancial crisis. In
February Jerome Powell, the chair of the Fed, told Congress some corporate debt
represented “a macroeconomic risk...particularly in the event of the economic downturn.”
Might American rms have overdone it?

Thanks to low interest rates and high pro ts, American companies are on average well able
to service their debts. The Economist has analysed the balance sheets of publicly traded
American non- nancial rms, which currently account for two-thirds of America’s $9.6trn
gross corporate non- nancial debt. Their combined earnings before interest and tax are big
enough to pay the interest on this mountain of debt nearly six times over. This is despite
the fact that the ratio of their debt, minus their cash holdings, to their earnings before
interest, tax, depreciation and amortisation (ebitda) has almost doubled since 2012.
But life is not lived on average. About $1trn of this debt is accounted for by rms with debts
greater than four times ebitda and interest bills that eat up at least half their pre-tax
earnings. This pool of more risky debt has grown faster than the rest, roughly trebling in
size since 2012. All told such debts are now roughly the same size as subprime mortgage
debt was in 2007, both in absolute terms and as a share of the broader market in which it
sits.
That a trillion dollars might be at risk is not in itself all that worrying. The s&p500 can lose
well over that in a bad month;Give
it did so twice in 2018. The problem with that $1trn of
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subprime debt was not its mere size; it was the way in which it was nanced. Mortgages of
households about which little was known were chopped up and combined into securities
Subscribers
few understood. enjoy
Those securities werepreferential
owned throughrates onchains
obscure our by
gifts.
highly leveraged
banks. When ignoring the stateGive
of the underlying
friends and familymortgages
access to The became impossible, credit
Economist
markets froze up because lenders via print,
did not know online
whereand the
our apps.
losses would show up. Big
publicly traded companies are much less inscrutable. They have to provide audited
nancial statements. Their bonds are traded in public markets. Their debt does not look
remotely as worrying, even if some rms are overextended.
Give me your funny paper

But there is a second way to cut a subprime-sized chunk of worry out of the corporate-debt
mountain. This is to focus on the market for so-called “leveraged loans”, borrowing which
is usually arranged by a group of banks and then sold on to investors who trade them in a
secondary marketplace. Borrowers in this market range from small unlisted rms to big
public companies like American Airlines. The stock of these loans has grown sharply in
America over recent years (see chart 3). They now rival junk bonds for market size, and
seem to have prospered partly at their expense. Unlike bonds, which o er a xed return,
interest rates on leveraged loans typically oat. They thus appeal to investors as a hedge
against rising interest rates.

Europe has a leveraged-loan market, too, but at $1.2trn, according to the most commonly
used estimate, America’s is about six times bigger. It is hard to judge the overlap between
these leveraged loans and the debts of fragile public companies. But it exists.
The rapid growth of leveraged loans is what most worries people about the growth in
corporate debt. The list of policymakers to have issued warnings about them, as Mr Powell
has done, include: Janet Yellen, his predecessor at the Fed; Lael Brainard, another Fed
policymaker; the imf; the Bank of England; and the Bank for International Settlements, the
banker for central banks. On March 7th the Financial Times reported that the Financial
Stability Board, an international group of regulators, would investigate the market.
These worries are mostly based on three characteristics the growth in leveraged loans is
held to share with the subprime-mortgage boom: securitisation, deteriorating quality of
credit and insu cient regulatory oversight.
The 2000s sawSubscribers

an explosion inenjoy preferential
the bundling rates on
up of securitised our gifts.
mortgages into collateralised
debt obligations (cdos) which went on to play an infamous role in the credit crunch. In
this context the collateralisedEconomist
loan obligations (clos)
via print, online andfound in the leveraged-loan market
our apps.
immediately sound suspicious. The people who create these instruments typically
combine loans in pools of 100 to 250 Give
while issuing
a gift for justtheir
£12 own debt to banks, insurers and
other investors. These debts are divided into tranches which face varying risks from
default. According to the Bank of England, nearly $800bn of the leveraged loans
outstanding around the world have been bundled into clos; the instruments soak up more
than half of the issuance of leveraged loans in America, according to lcd, the leveraged-
loan unit of s&p Global Market Intelligence.
For evidence of a deterioration in the quality of credit, the worriers point to the growing
proportion of leveraged loans issued without “covenants”—agreements which require
rms to keep their overall level of debt under control. So-called “covenant-light” loans have
grown hand in hand with clos; today they make up around 85% of new issuance in
America.
There are also worries about borrowers increasingly attering their earnings using so-
called “add-backs”. For instance, a rm issuing debt as part of a merger might include the
projected e ciency gains in its earnings before those gains materialise. When Covenant
Review, a credit research rm, looked at the 12 largest leveraged buy-outs of 2018 it found
that when such adjustments were stripped out of the calculations the deals’ average
leverage rose from 6.1 times ebitda to 8.7.
Regulatory slippage completes the pessimistic picture. In 2013 American regulators issued
guidance that banks should avoid making loans that would see companies’ debts exceed
six times ebitda. But this was thrown into legal limbo in 2017 when a review determined
that the guidance was in fact a full-blown regulation, and therefore subject to
congressional oversight. The guidance is now routinely ignored. The six-times earnings
limit was breached in 30% of leveraged loans issued in 2018, according to lcd.
In 2014 regulators drew up a “skin in the game” rule for clos—a type of regulation created
by the Dodd-Frank nancial reform of 2010 that requires people passing on risk to bear at
least some of it themselves. But a year ago the skin-in-the-game rule for clos was struck
down by the dc Circuit Court of Appeals. The court held that, since clos raise money rst
and only then buy up loans on behalf of the investors, they never really take on credit risk
themselves. Their skin is safe before the game begins.
In the middle of negotiations

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Despite these three enjoy preferential
points of comparison, though, the rates on ourmarket
leveraged-loan gifts. does not
really look like the subprime markets of the mid 2000s. clos have more in common with
actively managed investment Economist
funds than withonline
via print, the vehicles that hoovered up mortgage debt
and our apps.
indiscriminately during the mid-2000s. Those securities typically contained thousands of
mortgages; those selling them on hadGive
little interest
a gift in scrutinising the details of their
for just £12
wares. The clos pool fewer debts, their issuers know more about the debtors and their
analysts monitor the debts after they are bought. They need to protect their reputations.
Unlike the racy instruments of the housing boom, which included securitisations-of-
securitisations, clos have long been the asset of choice for investors wanting exposure to
leveraged loans. And they have a pretty solid record. According to Goldman Sachs, a bank,
in 2009 10% of leveraged loans defaulted, but top-rated clo securities su ered no losses.
The securitisation protected senior investors from the underlying losses, as it is meant to.
And the rise in covenant-light lending “is not the same thing as credit quality
deteriorating,” says Ruth Yang of lcd. It may just re ect the sort of investors now interested
in the market. Leveraged loans are increasingly used as an alternative to junk bonds, and
junk-bond investors think analysing credit risks for themselves beats getting a promise
from the debtor. Ms Yang points out that loans that lack covenants almost always come
with an agency credit rating, providing at least some degree of guaranteed oversight—if
not, perhaps, enough for those badly burned by the failure of such ratings in the nancial
crisis.
Even if these points of di erence amount to nothing more than whistling in the dark, the
prognosis would still not be too bad. America’s banks are not disturbingly exposed to
leveraged loans. The Bank of England estimates that they provide only about 20% of clo
funds, with American insurers providing another 14%. It also notes that the banks’
exposures are typically limited to the highest-quality securities. The junior tranches of clo
debt—those that would su er losses should defaults rise—are mostly held by hedge funds,
credit investors and the clo managers themselves. Even if a lot of them went bust all at
once access to credit for the economy at large would be unperturbed.
That said, defaults on loans are not the only way for corporate debt to upset the nancial
system. Take investment-grade corporate bonds. In 2012 about 40% of them, by value, were
just one notch above junk status. Now around 50% are. Should these bonds be downgraded
to junk—thus becoming “fallen angels”, in the parlance of debt markets—some investors,
such as insurance rms, would be required by their mandates to dump them. One study
from 2011 found that downgraded bonds which undergo such re sales su er median
abnormal losses of almost 9% over the subsequent ve weeks.
Another possible source of instability comes from retail investors, who have piled into
corporate debt in the decade since thevia
Economist crisis.
print,Mutual funds
online and have more than doubled the
our apps.
amount they have invested in corporate debt in that time, according to the Fed. The $2trn
of corporate debt which they own is thought
Give a giftto
forinclude
just £12 around 10% of outstanding
corporate bonds; the imf estimates that they own about a fth of all leveraged loans.
Exchange-traded funds (etfs), which are similar in some respects to mutual funds but
traded on stock exchanges, own a small but rapidly growing share of the high-yield bond
market.
In both sorts of fund investors are promised quick access to their money. And although
investments in mutual funds are backed by assets, investors who know that the funds
often pay departing investors out of their cash holdings have a destabilising incentive to be
the rst out of the door in a downturn. Some regulators fear that if ructions in the
corporate-debt market spooked retail investors into sudden ight from these funds, the
widespread need to sell o assets in relatively illiquid markets would force down prices,
further tightening credit conditions. There is also a worry among some experts that the
way in which middlemen, mostly banks, seek to pro t from small di erences in prices
between etfs and the securities underlying them could go haywire in a crisis.
Neither a widespread plummeting of angels nor a rush to the exit by investors would come
out of nowhere. The system would only be tested if it began to look as if more corporate
debt was likely to turn sour. There are two obvious threats which might bring that about:
falling pro t margins and rising interest rates.
Wipe that tear away

Until recently, interest rates looked like the bigger worry. One of the reasons markets
sagged in late 2018 was that the Fed was expected to continue increasing rates steadily in
2019. Credit spreads—the di erence between what corporations and the government must
pay to borrow—rose to their highest since late 2016. Leveraged loans saw their largest
quarterly drop in value since 2011 and a lot of money was pulled out of mutual funds which
had invested in them. By December new issuance had ground to a halt.
But in January Mr Powell signalled that the central bank would put further rate rises on
hold, and worries about indebtedness faded. Stocks recovered; credit spreads began falling,
leveraged loans rallied strongly. In February clo issuance exceeded its 12-month average,
according to lcd. It no longer looks as if high interest rates will choke the supply of
corporate credit in the near future.

Briefing Carryin
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The more signi cant threat is now falling pro t margins. Corporate-tax cuts helped the
earnings per share of s&p 500 rms grow by a bumper 22% in 2018. But this year pro ts are
threatened by a combination of wages that are growing more quickly and a world economy
that is growing more slowly. Pro t forecasts have tumbled throughout the rst quarter;
many investors worry that margins have peaked. Should the world economy continue to
deteriorate, the picture will get still worse as America’s scal stimulus wears o . The most
indebted businesses will begin to run into trouble.
If the same growth in wages that squeezes pro ts leads the Fed to nally raise rates while
the market is falling, the resulting economic squeeze would compress pro t margins just
as the cost of servicing debt rose. A wave of downgrades to junk status would spark a
corporate-bond sell-o . The junior tranches of clo debt would run into trouble; retail
investors would yank their money from funds exposed to leveraged loans and corporate
bonds. Bankruptcies would rise. Investment would drop, and so would the number of new
jobs.
That worst-case scenario remains mild compared with the havoc wrought by cdos a little
over a decade ago. But it illustrates the fragilities that have been created by the credit boom,
and that America could soon once again face a debt-driven turn in the business cycle that
is home grown.
After all, though the current rise in corporate
Economist via print, debt
onlineis not
and ourin itself a likely cause for a coming
apps.
crash, the past suggests that it is an indicator both that a recession is on its way and of the
damage it may do. Credit spreads haveGive
in ageneral been
gift for just £12 shrinking, a quiet before the storm
which tends to presage recession, though the link is far from certain. And recessions that
come after borrowing rates have shot up tend to be worsened by that fact, perhaps because
when people are lending a lot more they are, more or less by de nition, being less choosy.
In 2017 economists at the Bank of England studied 130 downturns in 26 advanced
economies since the 1970s, and found that those immediately preceded by rapid private
credit growth were both deeper and longer. That does not prove that the growth in purely
corporate debt will be as damaging. But it is worth thinking on.
This article appeared in the Brie ng section of the print edition under the headline "Carry that weight"
Print edition | Briefing

Mar 14th 2019
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18/03/2019 Should the world worry about America’s corporate-debt mountain?

- Carrying the weight

Carrying the weight

Should the world worry about America’s corporate-

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The 2000s sawSubscribers

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