In recent weeks, the Federal Reserve, the International Monetary Fund and major institutional investors such as BlackRock and American Funds all have sounded the alarm about the mounting corporate obligations.
The danger isn’t immediate. But some regulators and investors say the borrowing has gone on too long and could send financial markets plunging when the next recession hits, dealing the real economy a blow at a time when it already would be wobbling.
Some of America’s best-known companies, including AT&T, General Motors and CVS Health, have splurged on borrowed cash. This year, the weakest firms have accounted for most of the growth and are increasingly using debt for “financial risk-taking,” such as investor payouts and Wall Street dealmaking, rather than new plants and equipment, according to the IMF.
Amid the avalanche of debt, the sharp growth in lower-quality corporate bonds, just one notch above junk, represents a special concern. Investors hold nearly $4 trillion in these bonds, including $2.5 trillion from U.S. companies, according to the credit rating agency Standard & Poor’s.
Since Oct. 1, familiar names like Hasbro, Nordstrom, Marriott and Hyundai all have tapped investors for cash by selling near-junk bonds that S&P labels “BBB.”
This low-quality corporate debt bulge, by itself, is unlikely to cause a recession, according to economists and investors. But it could make the next one much worse.
“We are sitting on the top of an unexploded bomb, and we really don’t know what will trigger the explosion,” said Emre Tiftik, a debt specialist at the Institute of International Finance, an industry association.
The corporate worries darken an otherwise bright economic picture. On Wednesday, there was a flurry of upbeat reports, including rising orders for big-ticket items and a decline in first-time claims for unemployment aid.
With abundant jobs and rising wages, Americans seem to have dodged this summer’s recession fears. Growth is steady, if far short of the dramatic uptick President Trump promised.
The root cause of the debt boom is the decision by the Federal Reserve and other key central banks to cut interest rates to zero in the wake of the financial crisis and to hold them at historic lows for years.
The low rates were needed to encourage companies to invest and hire as the nation recovered from the worst economic collapse in 70 years.
Cutting interest rates is the standard answer to a troubled economy. But rates have never been this low for this long, and the side effects from too much easy money are becoming clear as central bankers struggle to return interest rates to traditional levels.
“This is part of a much bigger issue: an increased amount of collateral damage and the unintended consequences of an excessive reliance on central bank liquidity,” said Mohamed El-Erian, chief economic adviser to Allianz, the German financial services giant.
The president, who borrowed heavily as a private businessman in the real estate industry, has cheered the low-rate environment and demanded further Fed action that would encourage even more borrowing.
The United States is outperforming other advanced economies in Europe and Japan. But over the past four quarters, the economy grew at just a 2.1 percent annual rate, virtually unchanged from its 2.2 percent average since the recession ended in mid-2009.
El-Erian and others worry that an artificial environment of near-free money is masking serious underlying ailments and may be storing up problems for a future reckoning. This era of perpetually cheap money has kept alive some debt-ridden “zombie” companies that would have failed if rates were at traditional levels; widened the wealth gap between rich and poor; and distorted financial decisions, he said.
Indeed, today’s environment remains an alien world for financial market veterans. Low-rated companies can borrow at rates that only the most financially sound corporations enjoyed just a few years ago.
That could change quickly if the economy unexpectedly deteriorates. Though most economists now expect the United States to continue growing through next year, an unexpected shock — from a breakdown in U.S.-China trade talks or perhaps a military conflict in the Persian Gulf — could derail those forecasts.
Credit rating agencies would likely react to a slowing economy by downgrading companies that have issued the lower-quality bonds, turning those suspected of being unable to cover their interest payments into “fallen angels.”
That would force some mutual funds, insurance companies and pension officials — which are allowed to hold only investment-grade bonds — to unload their holdings.
In a flash, as all those fallen angels fell into junk territory, there would be too much speculative-grade debt for the market to absorb. Companies that already would be seeing profits shrivel from the downturn would suddenly face higher interest rates, chilling investment, forcing layoffs and spreading pain throughout the economy.
“You can definitely think of an Armageddon scenario,” said Gregory Venizelos, senior credit strategist for AXA Investment Managers in London.
Earlier this week, Robert Kaplan, president of the Federal Reserve Bank in Dallas, told CNBC that just “two or three downgrades” could cause investors to demand higher interest rates to buy corporate bonds. That would depress an already sluggish economy.
“We’re more vulnerable to that now with this amount of corporate debt,” said Kaplan, a former Goldman Sachs banker.
If downgrades occurred at the same rate as during the 2009 crisis, the volume of debt hitting the market could be well above the normal daily sales, the Bank of International Settlements in Basel, Switzerland, warned earlier this year.
Rather than reducing their risky debts, companies are adding to them. With the Fed having cut rates twice since July, companies continue to tap investors for enormous sums of money. In September, U.S. corporations issued $220 billion in new bonds, the largest single monthly figure in more than two years, according to the Fed.
Lured by low rates, companies have splurged on debt to repurchase their own shares, pay higher dividends to investors and fund acquisitions, the IMF noted last month, contrasting those increases with what it called “subdued” capital investment. Corporations have spent more than $3 trillion over the past five years buying back their own stock, according to S&P.
Earlier this month, for example, Hasbro issued $2.4 billion worth of bonds, with interest rates as low as 2.6 percent, to help fund its acquisition of a London-based entertainment company. Since 2009, Hasbro has increased its total debt by almost 60 percent, according to data compiled by Bloomberg.
In documents prepared for investors, Hasbro justified the borrowing by saying the acquisition would provide “meaningful financial benefits,” including higher earnings.
Last month, in its twice-yearly financial stability report, the Fed warned about the potential consequences of the market’s failure to police the rapid increase in risky corporate debt.
During the 2009 crisis, “BBB-rated” companies — the lowest rung of investment-grade — faced borrowing costs almost 7 percentage points higher than higher-quality companies. Today, the difference, or “spread,” is just 1.4 percentage points.
The risk of fire sales by institutional investors is real. Mutual funds have tripled their corporate bond holdings over the past decade. At $1.5 trillion, they now amount to about one-sixth of all corporate bonds on the market, according to the Fed.
In a crisis, mutual fund investors and managers will be operating at different speeds. Individuals can pull their money at the end of each trading day, but fund managers won’t be able to sell the actual bonds that quickly. This mismatch “creates conditions that can lead to runs on these funds in times of stress,” the Fed warned last month.
If the junk market were to be sufficiently disrupted, companies could be forced to default on their debts. That would likely force massive layoffs and sharp reductions in business investment, turning the financial market’s headache into a punishing economic ill, economists and money managers said.
“It’s going to amplify everything,” said Krista Schwarz, a finance professor at the University of Pennsylvania’s Wharton School. “It’s going to make everything happen faster, larger, worse. The recession would just be that much deeper.”
Some analysts play down the risks. Much of the rise in the amount of BBB bonds stems from deep-pocketed companies that were downgraded as the result of strategic choices rather than poor financial management.
“The financial crisis created a lower-cost borrowing environment,” said Gibson Smith, a prominent bond fund manager with Denver-based Smith Capital Investors. “Companies have done the rational thing. If you tell them they can borrow cheap and borrow long, they will take advantage of it.”
The bond market should be able to absorb whatever downgrades result from a poor-performing economy, Smith said.
Other companies issuing the low-rated bonds, such as AT&T, are financially sound and could meet any crisis by cutting dividends or capital expenditures, or selling assets, some analysts said. The telecommunications giant is more likely to win a higher credit rating than to suffer a downgrade, Smith said.
Whenever the easy-money era ends, investors will be left to decide how much of the historic debt run-up was well spent.
“We’ve tried to keep things going by encouraging debt,” said AXA analyst Venizelos. “Perhaps in hindsight, it should have been used better for capital expenditures and productivity, and that’s what concerns us.”