A few months ago, I wrote about the The Fed Dilemma. I have since then discussed the various points in more details. The last financial crisis was primarily caused by high leverage among households and financial institutions. Banks have deleveraged significantly since then and that is true for most households as well. I still see cause for concern in some real estate markets and other debt by lower income households, which I have discussed before. However, it is fair to say the U.S. government and non-financial corporations is where we now see more risks.
My main concern is the ever-widening deficit, the massive treasury issuance and overall amount of government debt and liabilities. It was recently discussed in this article. It is not necessarily the government debt which is concern in a stand-alone environment. It is the sheer size of the treasury issuance at a time when interest rates are increasing. This has the potential to push up longer-term rates even more, but also increase spreads for corporate, mortgage and consumer debt.
On an absolute level we can see that the amount of non-financial corporate debt has increased significantly since before the financial crisis.
Figure 1 - Source: fred.stlouisfed.org
In comparison to GDP we can also see that we are at an all-time high. What the below graph also shows is the apparent disconnect compared to history for default rates for high yield bonds when leverage is high.
Figure 2 - Source: @ReutersJamie - twitter
It is not only the level of corporate debt which is concerning but the composition of the debt. About half of the investment grade debt is now BBB rated, just one downgrade from junk, which would very likely cause a significant amount of forced selling due to the way many investment mandates are structured. The growth of lower rated investment grade debt over the last decade is spectacular to say the least.
On top of a higher portion of riskier debt, the risky portion seems to have gotten riskier as well with higher leverage and weaker covenants. In the event of defaults, the recovery rate will in turn likely be significantly lower. The leverage is illustrated for leveraged loans in the chart below, but similar trends apply for other types of debt as well.
Figure 5 - Source: ft.com
Another data point that illustrates the increased leverage is the growing number of zombie firms which are unable to pay interest expense from earnings. The below charts from the Bank for International Settlements shows this trend in a global database, but the report also points out that the companies survive longer in this state. It is worth keeping in mind that the report is for a period when interest rates have consistently decreased, which might not be the case going forward.
Figure 6 - Source: bis.org
Despite the amount of debt and composition of the debt, credit spreads remain relatively low. Naturally the yields have come up because government rates have increase, but so far there is very little stress in the corporate debt market.
I also think it is worth considering the number of weak buyers and perceived liquidity which is associated with the growth of ETFs. Historically, many bonds were held to maturity by pension funds and institutional investors. However, the increased reliance on ETFs has the potential to create more significant short-term volatility which could feed on itself if we do see spreads start to increase.
The leverage in the non-financial corporate debt has the potential to accelerate a market downturn significantly. It is important to point out that spreads are so far relatively muted. I will primarily be watching the treasury issuance going forward and the effect that will have on the longer-term governments rates. I will also be following the corporate and mortgage spreads carefully. If the spreads start going in the wrong direction, it could turn very quickly, at least until the FED reverses course.
Despite the fact that there is no stress in the market, I am staying far away from any long-term bonds as the added yield is not nearly enough compensation for the increased risk many seem to overlook.
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