The coronavirus threatens the global economy and financial markets. But the same goes for another less obvious peril: the mountain of risky debt issued by companies and bought by investors during the recent economic expansion.
Repaying this debt will be difficult for the companies that issued it if their revenues fall due to the coronavirus. Default, defaults and investment losses are likely, according to analysts, to subject the economy to what economists call a negative feedback loop.
Debt levels in the United States are at record levels and riskier debt markets – like high-yield corporate bonds – have been warning signs. Buyers of riskier debt are also withdrawing from the markets, analysts report. In mid-February, for example, a high-yield bond index was up almost 1.2% for the month, according to LevFin Insights, an analysis firm. At the end of the month, the index was down 1.5%.
We have already seen this film. In 2008, billions of dollars of mortgage debt accumulated during a huge surge in residential real estate had to be unwound, contributing to a deep and destructive global recession.
This time, another type of debt is looming: commercial loans. Outstanding US non-financial corporate debt stood at $ 10.1 trillion in the third quarter of 2019, up from $ 7.1 trillion in 2013, according to the Federal Reserve Board.
Traditionally, the amount of outstanding business debt has been lower than that of residential mortgages, but now the two are neck and neck. For the first time in modern history, commercial loans are the largest group of assets held by banks, surpassing mortgages, which had been the main portfolio.
“Not only has there been a sharp increase in corporate debt, but the quality of debt is the lowest it has ever been,” said David Rosenberg, chief economist at Rosenberg Research, a consulting firm in investment. “The last cycle involved the household sector and commercial banks. It is the business sector and the holders of the false debt are mutual funds, insurance companies and hedge funds.”
Some features of today’s debt frenzy are very similar to the previous one: before the virus hit, rising stock and bond prices had fueled a complacent conviction among investors that asset prices could not that go up, a bit like during the residential housing boom that preceded 2008. crisis. This complacency has resulted in an increased risk appetite among hedge funds, mutual funds and insurance companies looking for gains in their portfolios.
Congress and financial regulators have also played a role in the current credit bubble, as they did in the last one, said Joshua Rosner, director of Graham-Fisher, an independent research firm. In 2018, Congress and financial regulators relaxed the rules, encouraging investors to increase their borrowing. The rules were also relaxed for residential borrowers in the run-up to the 2008 crisis.
Because companies have buzzed and stock prices have gone up, debt hasn’t been a big concern, said Vicki Bryan, founder of Bond Angle, a high-yield bond research company.
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“The debt has been completely ignored – it’s like the addictive drug that everyone thinks is acceptable, until it isn’t,” Bryan told NBC News. Now, she added, the problem is what the debt-issuing companies have done with the product. Rather than using it to invest in their operations or strengthen their financial positions, many have chosen to buy back their stocks or pay dividends to investors.
“It weakened the system,” said Bryan. “It reduces the margin these companies have in the event of a problem.”
According to the Fed, the fastest growing segment of the corporate debt market has been leveraged loans, those made to companies with poor credit histories or high debt levels . These loans totaled $ 1.1 trillion in 2019, an increase of 15%.
In a speech last May, Jerome Powell, chairman of the Federal Reserve Board, noted that corporate debt issuance has recently focused on the riskiest segments and layoffs could result. “Some companies could face serious financial difficulties if the economy deteriorates,” he said in the speech. “A highly leveraged corporate sector could amplify any economic downturn as companies are forced to fire workers and reduce their investments.”
Mutual funds have been big buyers of corporate debt. Last year, funds held a record $ 1.53 trillion in business loans, up from $ 504 billion in 2009, according to the Fed.
Massive investor redemptions could be a problem for these mutual funds, Fed researchers noted in a report last November. “The time lag between the ability of investors in open-ended mutual funds and bank loans to redeem their shares daily and the often longer time required to sell bonds or corporate loans creates conditions that can lead to ruptures of funds on these funds in times of tension, “wrote the researchers.
Bryan, the bond analyst, agreed. “The high-yield market tends to grab when something is really bad,” she said. “The liquidity that you count on the stock market is not a given.”
Investors have also increased their debt in recent years, using borrowed money to buy assets, according to data from the Federal Reserve. While using investor returns on debt juice as asset prices rise, they magnify losses, forcing managers to put in extra money or sell losing stakes.
Hedge funds as leverage. The most recent data from the Federal Reserve shows that on average, gross assets of hedge funds, including borrowings, represented 7.7 times their net assets in December 2018, compared to 5.4 times in 2013. This means that for every dollar of outright loss they incur, they’re on the hook for $ 7.70.
Of course, these funds are supposed to hedge their positions, by means such as the implementation of transactions which benefit from a falling market to compensate those which profit from a rising market. Compensation operations like these will provide protection in a rout.
However, regulatory filings confirm significant levels of debt with certain hedge funds. In January, for example, Citadel Advisors had invested $ 194 billion, including leverage. Its most recent net worth, meanwhile, was $ 27.5 billion, translating into leverage of about seven to one.
A spokeswoman for the Citadel declined to comment on its leverage.
Another example is ExodusPoint Capital. A relatively new hedge fund that oversees $ 8.7 billion after its launch in 2017, ExodusPoint’s leveraged assets stood at $ 90 billion at the end of 2019, a ratio of around 10 to a.
ExodusPoint did not respond to a request for comment.
Deregulation, a favored policy of the Trump administration, has also fueled the debt frenzy. In 2018, regulators and Congress relaxed the rules governing corporate borrowing, allowing for greater leverage in the system and increasing the risks associated with these borrowers.
A change came in the spring of 2018, when Congress passed legislation allowing business development companies, closed-end investment companies that lend to small and medium-sized businesses, to double their maximum leverage. . Business development companies with publicly traded stocks are highly valued by investors seeking high returns.
Then, in September 2018, the country’s main banking regulators made a big change that involved leveraged borrowers.
For years, the three main banking regulators, the Fed, the FDIC and the Money Controller, have become accustomed to identifying the so-called “clear line” thresholds in their supervision guidelines to be followed by banks. One such threshold concerned leveraged lending, regulators warning banks against lending money to companies that already had loans more than six times a measure of profits.
But in the fall of 2018, the three regulators said that the previous thresholds should not, in fact, be considered binding by the banks they supervise. This allowed the institutions to lend money to already highly indebted institutions.
After almost 10 years of economic growth and rising corporate debt, it was not the right thing to do at the wrong time, said Rosner of Graham-Fisher & Co. “Regulators have been complicit in supporting leverage in the system to maintain economic growth when they should have been concerned about security and solidity, “he said.
