Why The Corporate Debt Bubble May Burst Sooner Than You Think

LINKEDINBY MARK KOLAKOWSKI  Updated Feb 20, 2019

Record high corporate debt threatens the bond market, the stock market, and the broader economy, in the opinion of several respected analysts. One of them is Stephanie Pomboy, founder of economic consulting firm MacroMavens. More than a decade ago, she correctly warned of the impending subprime mortgage crisis, a key precursor of the more general financial crisis that followed in 2008.

Now Pomboy sees troublesome similarities in today's debt markets. "In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time, the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid,” Pomboy said in a lengthy interview for a column in Barron's. In the U.S. alone, there is about of $5.5 trillion of corporate debt with low or marginal quality, as detailed in the table below.

The Corporate Debt Bubble Is Getting Bigger

Source: Barron's

Significance For Investors

The definition of a leveraged loan is somewhat fluid, but the basic concept is that the borrower already is saddled with significant debt, and thus represents significant risk to the lender. Junk bonds, also called high yield bonds, are corporate debt obligations that are rated below investment grade.

Pomboy warns that high-yield ETFs pose a particular risk today, similar to that created by collateralized debt obligations (CDOs) in 2007-09. Back then, banks unloaded vast numbers of shaky subprime mortgages on securities firms. These mortgages were then packaged into debt instruments that somehow received high ratings, which, in turn, facilitated their sale to the investing public. When overextended borrowers began defaulting on those underlying mortgages, the value of these debt instruments built upon them cratered.

Today, ETFs that hold portfolios full of low-quality, thinly-traded corporate debt promise investors "abundant and immediate liquidity" that is as illusory as the quality of those mortgage-backed CDOs more than a decade ago, as Pomboy told Barron's. "These vehicles are only liquid in one direction," she insists. That is, there has been a significant reduction in the number of market makers and potentially willing institutional investors who are likely to step in and stabilize prices should a wave of selling hit these ETFs. Meanwhile, Bank of America Merrill Lynch finds that the liquidity premium in the high-yield market, or the extra yield that compensates investors for holding illiquid bonds, is at its lowest since 2007, per Barron's.

Adding to the risks, Pomboy observes, is that some of these high yield ETFs use leverage to magnify gains, while many investors buy on margin for the same purpose. The problem is, the use of leverage and margin also tends to further magnify losses when prices tumble.

Putting U.S. corporate debt loads in a broader perspective, the total amount has surpassed $9 trillion and equals more than 45% of annual U.S. GDP, per CNBC. Former Federal Reserve Chair Janet Yellen is among those who warn that this mountain of debt could "prolong" an economic recession and cause a wave of corporate bankruptcies.

"Overall, credit vulnerabilities look greater than when we last looked in 2017; the corporate credit channel in particular could worsen a global economic slowdown," writes Adam Slater, lead economist for Oxford Economics, in a recent note to clients quoted by MarketWatch. He sees the possibility of a "negative 'financial accelerator' effect with higher defaults" worsening an economic downturn.

Looking at large economies worldwide, Oxford Economics finds that 60% of world GDP is in economies with "risky" corporate debt, while 30% is in economies with risky household debt, per Business Insider. In another lengthy interview with Barron's less than a year ago, Pomboy identified massive consumer debt as a key risk for the U.S. economy and stock market.

Oxford Economics also indicates that the quality of leveraged loans is at all-time lows in both the U.S. and Europe, after a rush of new deals in recent years. Additionally, they find that global private sector debt is a higher percentage of world GDP than before the 2008 crisis.

Looking Ahead

Bond bulls may be quick to point out how many times the bears and the doomsayers have been wrong in recent years. On the other hand, the European Central Bank studied 175 credit booms across the world from 1970 to 2016, and found that 33% were followed by a banking or financial crisis within three years after the boom's end. Whether investors can fully protect themselves for the next credit bust is an open question.

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