This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
During this prolonged period of low interest rates, U.S. corporate debt has increased to levels above those seen prior to the financial crisis in 2008.
The International Monetary Fund (IMF) has warned presciently. When the Federal Reserve raises interest rates, this poses a potential threat to markets and banks. Higher borrowing costs could make it increasingly difficult for firms to service their debts. For instance, the 10-year U.S. Treasury risk-free rate, the benchmark for long-term corporate rates, has increased from 2.6% towards 2.9% in recent months.
While borrowing costs are only slowly rising, interest expense as a proportion of corporate income has risen dramatically. A report by S&P warns us. A report by the bond rating agency S&P warns us. A debt to earnings ratio of 5 times (5X) is a rubicon. This is where interest rate stress on major companies gets worrisome. The number of major companies above that 5X level rose +37% in 2017 alone.
Up to this point in time, this high an amount of debt service has been accompanied by an exceptionally low default rate. In turn, that is driven by a healthy economy and the ‘easy money punchbowl’.
The question in investor’s mind is: How will firms handle rollover risk -- once rising credit risk spreads and interest rates increase the cost of borrowing -- beyond what we have already seen?
1) Since the beginning of 2018, U.S. and European companies have raised less money than in prior years. During many prior years of heavy debt accumulation, they apparently ignored the risk of a quick burst in interest rates. This could be partly due to speculation, or hope, for a quick recovery of the bond markets after any strong rise in rates.
2) While we are in a rising interest rate environment in 2018, borrowing costs still remain at record low levels. We noted an average of long-term rate of 3% around the world compared to 4.5% in the previous two decades.
3) In our minds, the 10-year U.S. Treasury yield still offers a very competitive yield, when matched to comparable sovereign rates in international markets. We think the upside potential to that key benchmark rate will continue to be curbed by demand from foreign investors. Therefore, risk-free U.S. borrowing costs benchmarks -- in our expectation -- won’t rise excessively.
4) Consult the next graph. You can see that the spread on corporate bonds relative to the yield on a 10-year U.S. Treasury has increased only slightly since the beginning of 2018. Early 2018 yield levels are still very close to what we saw prior to the financial crisis (2005 to 2007). They are not a reason for concern yet.
5) It will remain crucial for the further development of corporate debt markets how credit risk spread relationships develop. Any credit risk spikes will curb corporate debt enthusiasts and should help to keep excessive borrowing in line.
6) The Chicago Fed National Financial Conditions Index (NFCI), depicted below, supports a sanguine view. The recent tightening in financial conditions is still relatively subdued. Current NFCI levels are still very close to those we observed prior to the financial crisis.
7) According to an IMF study, companies with a particular high interest expense to earnings ratio are clustered in the energy, utility, and real estate sectors. These are ‘worry’ sectors.
8) Due to a number of robust earnings seasons, investment grade firms have accumulated record amounts of cash. This will help to insulate them from market turbulence.
9) It seems the risk of not being able to service corporate debt is not equally distributed across the board. Rather, it impacts a subgroup of one third of companies -- according to Citi Group. They tell us these companies face returns on invested capital that are outweighed by the weighted average cost of funding found in the 1,600 companies that make up the MSCI World Index. Due to this concentration of firms with ‘unhealthy’ capital investment returns, we remain apprehensive about the possibility for corporate leverage to be a trigger for a large downturn in the economy
In sum, we expect the U.S. economy still provides solid growth potential. This provides an ample opportunity for most investment grade companies to continue to service their debts and remain on solid footing -- despite any increasing cost of borrowing. It will remain important, however, to keep a close watch on high-yield corporate debt.
That will be the debt sector to feel the pinch first. We do not expect corporate leverage to have the power to trigger the next downturn. But risky corporate debts surely will exacerbate the effect of any weakening economy. The firms with the lower credit ratings will suffer from much higher financing costs then.
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Corporate Leverage: A Catalyst for the Next Downturn or Just Fuel to the Fire?
This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
During this prolonged period of low interest rates, U.S. corporate debt has increased to levels above those seen prior to the financial crisis in 2008.
The International Monetary Fund (IMF) has warned presciently. When the Federal Reserve raises interest rates, this poses a potential threat to markets and banks. Higher borrowing costs could make it increasingly difficult for firms to service their debts. For instance, the 10-year U.S. Treasury risk-free rate, the benchmark for long-term corporate rates, has increased from 2.6% towards 2.9% in recent months.
While borrowing costs are only slowly rising, interest expense as a proportion of corporate income has risen dramatically. A report by S&P warns us. A report by the bond rating agency S&P warns us. A debt to earnings ratio of 5 times (5X) is a rubicon. This is where interest rate stress on major companies gets worrisome. The number of major companies above that 5X level rose +37% in 2017 alone.
Up to this point in time, this high an amount of debt service has been accompanied by an exceptionally low default rate. In turn, that is driven by a healthy economy and the ‘easy money punchbowl’.
The question in investor’s mind is: How will firms handle rollover risk -- once rising credit risk spreads and interest rates increase the cost of borrowing -- beyond what we have already seen?
1) Since the beginning of 2018, U.S. and European companies have raised less money than in prior years. During many prior years of heavy debt accumulation, they apparently ignored the risk of a quick burst in interest rates. This could be partly due to speculation, or hope, for a quick recovery of the bond markets after any strong rise in rates.
2) While we are in a rising interest rate environment in 2018, borrowing costs still remain at record low levels. We noted an average of long-term rate of 3% around the world compared to 4.5% in the previous two decades.
3) In our minds, the 10-year U.S. Treasury yield still offers a very competitive yield, when matched to comparable sovereign rates in international markets. We think the upside potential to that key benchmark rate will continue to be curbed by demand from foreign investors. Therefore, risk-free U.S. borrowing costs benchmarks -- in our expectation -- won’t rise excessively.
4) Consult the next graph. You can see that the spread on corporate bonds relative to the yield on a 10-year U.S. Treasury has increased only slightly since the beginning of 2018. Early 2018 yield levels are still very close to what we saw prior to the financial crisis (2005 to 2007). They are not a reason for concern yet.
5) It will remain crucial for the further development of corporate debt markets how credit risk spread relationships develop. Any credit risk spikes will curb corporate debt enthusiasts and should help to keep excessive borrowing in line.
6) The Chicago Fed National Financial Conditions Index (NFCI), depicted below, supports a sanguine view. The recent tightening in financial conditions is still relatively subdued. Current NFCI levels are still very close to those we observed prior to the financial crisis.
7) According to an IMF study, companies with a particular high interest expense to earnings ratio are clustered in the energy, utility, and real estate sectors. These are ‘worry’ sectors.
8) Due to a number of robust earnings seasons, investment grade firms have accumulated record amounts of cash. This will help to insulate them from market turbulence.
9) It seems the risk of not being able to service corporate debt is not equally distributed across the board. Rather, it impacts a subgroup of one third of companies -- according to Citi Group. They tell us these companies face returns on invested capital that are outweighed by the weighted average cost of funding found in the 1,600 companies that make up the MSCI World Index. Due to this concentration of firms with ‘unhealthy’ capital investment returns, we remain apprehensive about the possibility for corporate leverage to be a trigger for a large downturn in the economy
In sum, we expect the U.S. economy still provides solid growth potential. This provides an ample opportunity for most investment grade companies to continue to service their debts and remain on solid footing -- despite any increasing cost of borrowing. It will remain important, however, to keep a close watch on high-yield corporate debt.
That will be the debt sector to feel the pinch first. We do not expect corporate leverage to have the power to trigger the next downturn. But risky corporate debts surely will exacerbate the effect of any weakening economy. The firms with the lower credit ratings will suffer from much higher financing costs then.