Amidst the superficially sunny environment of stock market highs and unemployment lows, there are other metrics that simply aren’t comporting with the popular picture of financial health. When we take an overview of the last year, murmurings of a corporate debt bubble on the verge of popping have undergone a marked increase. The Federal Reserve has even gotten in on the action, warning about the shaky, rapidly expanding edifice that is aggregate corporate debt in their November 2019 Financial Stability Report.
A month earlier, in a global portraiture of the economy, the International Monetary Fund expressed an equally strong unease. They noted that the “prolonged low-interest-rate environment in advanced economies has encouraged risk‑taking, including among institutional investors, [leading] to a continued build‑up in financial vulnerabilities”.
Both of these organizations are attuned to surveying the economy from a lofty perch with an eye towards macroeconomic trends. Circling like an eagle from above, they watch for the shadows that might portend trouble. Economic downturns are their eternal nemesis, the elements of which often grow strength in secret. Now, monetary officials and individual investors alike have noticed this particular storm cloud for the threat that it is and are nervously pointing at it in greater numbers.
It’s impossible to predict the precise ramifications of this trend, but it’s certainly worth combing out how we got to such historically high levels of corporate debt in the first place. Nonfinancial corporate debt recently surpassed $10 trillion and clocking in at 47% of GDP, has reached highs that the U.S. has never seen before.)
How did we get here?
For this exploration, as with many others, we have to look back to the greatest financial crisis of the 21st century. The emergency actions mounted back then help spell out the situation that we find ourselves in today. The IMF is right: Sustained suppression of interest rates did indeed lead to businesses gulping up debt.
After all, they were responding to “favorable market conditions”; they were taking advantage of easy money, of cheap debt. It’s the same principle, roughly speaking, behind you going into the store with a great sale going on, capitalizing on the low prices, and loading your cart up with stuff. Had interest rates not been pressed down for so long, it’s conceivable that business debts might not be where they are today.
Although the Fed did go about raising rates for a brief spell in the past number of years, they reversed course for the whole of 2019 and don’t show sure signs of stopping anytime soon.
Many commentators on the corporate debt spectacle also agree that asset prices are high and climbing, delving into bubble territory themselves. There’s an interesting link between overvalued assets and debt levels and it’s basically that people have a higher threshold for risk when assets are appreciating fast.
When the market ascends somewhat rapidly, there are often two not-so-great pernicious effects that occur: 1) People don’t tend to figure out why it’s going up or at least take a turn on the skeptic’s side of the room and 2) from this, they fail to imagine that the potential descent (if they contemplate one, that is) could be just as hard and fast as the ascent.
Thus, the easy-money policy gushing out of the Fed for most of the decade coupled with the likely inflation of asset prices resulted in a distortion of the true risk associated with taking on business debt. It’s this distortion — this misunderstanding — that could potentially cause real economic hurt. And this problem is far from confined to the United States.
Most of the first-world nations simultaneously slumped over a decade ago; thereafter they have marched in lockstep to plenty of economic measures — corporate debt being one of these. Some European and Asian countries have corporate debt levels that make the U.S.’s look rather tame by comparison.
The puzzle piece that is stock buybacks
There’s been a lot of talk about stock buybacks lately and what exactly the nature of their aggregate effect is. Many people believe that the stock market is propped up by this particular trend. This is because stock buybacks are instrumental in driving the price of stocks up and with enough companies engaging in it, people start to buy into the perception that the stock market is more golden and buoyant than it actually is.
And when companies decide to sop up a bunch of their stock, they’re making a decision that they’d prefer to spend their cash this way rather than to engage in any number of other classically “productive” business pursuits. These include avenues such as capital expenditures, investments in employee welfare, and research and development. Critics are rightly concerned about buybacks because, in contrast to the aforementioned, they are, by definition, not productive.
Besides giving a short-term boost to share prices, no benefit accrues to the underlying financial status of the business in question. Fundamentals such as revenue, productivity, or profit are unchanged — which are the usual, healthy drivers of share price growth. Where the phenomenon of rising corporate debt ties into the rise of buybacks is that companies are levering up, and many times that’s to buy back their own stock! Not only are they taking advantage of cheap debt, but they’re also using it for a not-so-productive purpose.
As with a lot of things in life, it’s the question of why that is so often glossed over but constitutes the most sorely-needed discussion. So what concealed and unspoken incentive underlies the pattern of stock buybacks? We can assume that if businesses are preferring to buy back their own stock instead of funneling these funds (however debt-financed they are) into “productive pursuits” that they might not have a very optimistic view of the economy — and that’s worth pondering. They’re not prioritizing investment in their company’s future so much as they’re trying to temporarily protect their share prices in the present.
Not only is there more debt, but it’s worse quality
It’s not only the size of debt that is casting a worried pall over parts of the financial community, it’s the health of this debt — or, in the case of bonds, the rating. One of the consequences of ultra-low rates for many years was that it enticed businesses at the bottom of the food chain into taking on debt that they really shouldn’t have.
In keeping with the pattern of record-breaking, it’s been revealed that more corporate bonds than ever sit in the triple-B rating category or are hovering just above it. This is the lowest grade that a bond can receive before it retreats from “investment-grade” territory and into the land of junk bonds.
And the more you veer into junk bond territory, the closer you get to illiquidity. During recessions, it’s poorly-graded bonds that get hit first and it is these bonds that can intensify a crisis, wherein other rounds of downgrades are occurring and valuations are starting to circle the drain.
Who’s to say whether corporate debt would cause a crisis, but at the very least, it doesn’t make us any less protected against the next one. Sitting on a pile of unhealthy debt is synonymous with sitting on a pile of combustible material. It has destructive potential.
And let’s remember that bond ratings — despite having a stained track record of accuracy — are actually one of the most dangerous players in financial crises, inflaming a contagious downward spiral that sets off a chain reaction of forced selling, of liquidity pressures, of insolvency concerns.
The important point here is that the amount and quality of corporate debt might not be causing a mess in the markets now, but it could. Predictions of an approaching recession have been swirling in the past year and should such a slump come to pass, the built-up ammunition that has been corporate debt levels will start to show itself and make some noise. The severity of an economic jolt is naturally sure to increase when the players in the economy have become accustomed to a diet of debt-financing.
And generally speaking, when the economy is secure, businesses engage in more rational, future-minded pursuits and their risks are a bit more tempered, balanced-out in line with profitability, say. The preponderance of corporate debt and concerning developments such as high stock buybacks may be an indication that something’s remiss in the operations of the economy and it might not be as secure as some people think.
What happens if corporate debt implodes?
Businesses are the lifeblood of America. And the trend of large corporate debts travels from the highest company on the totem pole — Apple, for example — down to the smallest company — a restaurant in some little Minnesota town, say. If a recession hits, cash flows will decrease, and companies may find it hard to service their debt, let alone survive in some cases.
What’s worse is that their deleveraging will send asset prices on a downward rollercoaster ride. Any time you take on risk in good times (and at an attractive price, probably), and you try to get rid of it in bad times, you’re not going to get your money back.
As with a lot of financial jargon, “corporate debt” sounds like something deceivingly distant and academic. But in truth, it has the potential to affect all of our daily lives in very personal, distressing ways. The patterns of businesses and macroeconomic trends more broadly are important to scope out because they quite literally paint our future realities.
We also have to remember that build-ups in the financial system have to eventually work themselves out — and sometimes “working themselves out” means implosion. The stark truth is that financial crises are horribly damaging to the national psyche and they make profound dents in the timeline of history, altering the course of it so radically that its effect is second only to war.
Go back some years and recall the build-up of subprime mortgages and all the destruction that occurred in its wake. An unprecedented recession, large percentages of market value scrubbed from existence, hurting families and businesses, political unrest. The Fed and global financial institutions have a right to be concerned — and so should you.
There’s the stock market on one side of the divide, and the bond market on the other. One seems to be doing quite swimmingly, busily churning out higher and higher share prices, basking in its radiant success. But on the opposite side, the bond market tells a different story, rising in volume, degrading in value, and yet distorting in price.
Businesses get rewarded in the stock market all the while they’re collectively amassing more debt than ever before in recorded history. Simply put, the stories don’t line up. The realities clash. Something’s wrong — but here’s the ominous reminder — it will likely eventually be made right.