Corporate America has been indulging in a debt-issuing binge, thanks to ultra-low interest rates. The result is that a record share of corporate bonds now sits in the ratings tier just above junk status.
A record $2.96 trillion is rated Baa, the level right before high-yield, according to new data from Moody’s Capital Markets Research. That’s an unprecedented 48.5% of investment-grade bonds.
For now, this condition doesn’t appear ominous. The junk bond default rate at year-end 2018 was a mere 2.4%, down from 3.4% in 2017. Trouble is, once things go south, they can do so quickly.
In 2007, on the eve of the financial crisis, the default rate among speculative-grade bonds was about the same as now. The next year, however, it soared to 15%.
At the moment, there hasn’t been much in the way of company ratings downgrades. But of the 22 investment-grade downgrades in last year’s fourth quarter, Moody’s figures show, 15 were from Baa. The big reason for the surge in Baa credits isn’t downgrades, at this point. It’s that the bulk of newly issued bonds are rated Baa at the outset, because their companies have a lot of debt.
This expansion is partly due to an explosion of mergers and acquisitions. The big underlying reason for the debt feast, of course, has been the low rates, an era that is coming to an end with the Federal Reserve bent on jacking up short-term rates.
While long-term yields remain relatively low—2.75% for the benchmark 10-year Treasury, which is the major influence for corporate rates—that won’t stay static forever. Just last October, the 10-year T-note yielded 3.25%. (Global turmoil has since prompted investors, many of them foreign, to load up on the 10-year, pumping up its price and depressing its yield.)
The scary thing is that, in the estimation of Grant’s Interest Rate Observer, business debt as a percent of GDP tops 72%, which is more than the peak of the last economic up-cycle, 68.8% in 2017’s first quarter.
As financial pundit William D. Cohan recently wrote, vis-a-vis the corporate debt situation: “It’s been quite a party. Now comes the hangover.”