Will Corporate Debt Set Off the Next Financial Crisis?
Artificially low interest rates and monetary manipulation of the kind that the developed world, and more specifically the United States, have witnessed since the last financial crisis have consequences. One of them has been the ballooning of corporate debt in this country.
Regardless of how corporate America has used its access to tons of cheap new credit all these years (many companies, as is well known, have simply used it to buy back their own shares, whether it made sense or not, just to make their earnings per share look better), the result today is a highly dangerous level of debt at the heart of the economy.
Corporate debt was not one of the big culprits of the financial crisis a decade ago. But it might well be next time around. It has now reached $10 trillion, which means it is 60 percent higher than it was a decade ago. Its total size amounts to about half of the total size of the U.S. economy.
This is not a big deal, some may say, given that an overwhelming amount of corporate debt is rated as investment grade by rating agencies. But wasn’t that the case also with mortgage-related debt before the bubble burst in 2007/2008? Half of the debt given an investment grade by Standard & Poor’s today is actually bordering on junk status—i.e., its rating is the lowest in the investment grade scale. A total of $3 trillion in debt is currently in that situation. These companies’ debts can be downgraded to non-investment grade at any moment.
Nearly half of all outstanding corporate bonds will need to be refinanced before 2023, the year in which they will mature. Many companies will not be able to refinance their debt, given that their financial situation offers banks little guarantee that they will pay it off. The average debt-to-earnings ratio, not far from 4, is much higher than it was before the last financial crisis and nearing the level of the dotcom bubble. Clearly, a large number of corporations currently given the lowest investment grade by rating agencies are candidates for junk status. Once they are downgraded, they will trigger a massive sell-off by institutional investors such as pension funds whose rules do not allow them to invest in junk.
It doesn’t take much foresight to see that there won’t be many willing buyers of the bonds that these investors will have to dump on the market overnight, which in turn will cause a collapse in prices. Not to mention the disaster that the inability to refinance their debts will bring on the many corporations currently bearing the weight of too much debt relative to their earnings—that is, to their ability to service and repay it!
These realities are hidden below the surface of what currently looks like a dynamic economy with a rate of growth of 3.2 percent, according to the most recent data, and extremely low unemployment figures. It has always been the case with the consequences of currency manipulation and artificial monetary stimuli—until those hidden consequences eventually come bursting out into the open, setting off a financial crisis across the system.
The fact that consumer price inflation has been subdued in recent years (in large part because households were behaving more responsibly, because corporations were not spending their credit in goods and services but in financial assets) does not mean that all that money printing has not been having perverse effects in other areas of the economy, as we will eventually find out the hard way.