While the mainstream financial media finally realizes that everything’s “not so great” in the global economy – there’s even more to worry about.
I’m talking about the ticking time-bomb in the corporate debt market. Which I believe will play a large role in the next financial crisis.
Let me explain. . .
After years of corporations gorging on ‘cheap’ debt – thanks to the Federal Reserve’s post-2008 zero interest rate policy (ZIRP) – many are now at the edge of seeing their credit ratings downgraded.
To put things into perspective – according to S&P Global – there’s over $7 trillion worth of BBB-rated debt (including notes, bonds, term loans, and revolving credit lines) worldwide. (With $3.5 trillion belonging to U.S. firms).
Why does this matter?
Because BBB-rated debt is the last notch in the investment-grade (IG) level. And anything below is considered speculative grade (aka junk) – meaning there’s suddenly a much higher chance of default.
Now – before I go on – here’s some context about investment grade and junk debt. . .
When a credit agency (like S&P or Moody’s) labels a corporation’s debt investment grade (BBB and higher) – it’s technically saying that it believes based on the company’s current financials and economic outlook that the chance of a default is minor. (A firm with a higher credit rating means they pay less interest).
But when the credit agency labels a corporation’s debt junk (BB or lower) – it’s saying there’s a high chance that a firm may default on their creditors. (A firm with a lower credit rating means they pays more in interest).
Also – keep in mind that many institutional investors – such as insurance firms, pension funds, some mutual funds and exchange-traded funds (ETF’s) – can’t legally own anything lower than investment grade debt. (This means money managers would be forced to dump these holdings – leading to a sharp drop in bond prices).
Thus – you can see how fragile things are when 53% ($3.2 trillion) of the total investment grade debt category in the U.S. is BBB-rated. (Just one step away from being labeled junk).
All this is why I believe that the corporate debt market is nearing a ‘tipping-point’ – especially as economic conditions worldwide worsen. And dollar-liquidity continues drying up.
For instance – making matters worse – there’s roughly $1.9 trillion in BBB-rated U.S. corporate debt that’s maturing over the next four years. . .
This means many of these firms must either repay creditors the full principle owed with cash on hand. Or roll-over (refinance) their existing debt (meaning they will need take out new debt to repay old debt).
But – since most of these firms are near-junk already – I’ll assume most don’t have the cash on hand to repay the maturing debts. Thus needing to borrow more.
The problem is – if economic conditions continue to sour – then these BBB-rated firms will be stuck between a rock-and-hard-place.
On the one side – during an economic downturn – creditors hold more cash or buy U.S. government bonds. (Some may lend to firms, but only those of the highest quality). So they won’t be freely lending to near-junk rated firms.
And on the other side – during an economic downturn – these BBB-rated firms will be at risk of their credit ratings dropping as their earnings decline. Making it even more difficult to find creditors willing to lend them capital.
Thus – it’s clear if the global economy continues weakening that these firms won’t have access to cash when they need it most. (Which is historically what leads to a wave of corporate defaults). . .
So – in summary – the massive amount of near junk-rated debt (BBB) has put investment grade bond holders (pension funds, insurance firms, etc) in a very fragile position. Especially as economic conditions continue declining.
Making matters worse – most of these firms only piled on debt to fulfill short-term agendas – such as buying back stock or paying dividends.
But such superficial tactics rarely ever work out well in the long-term.
Thus – in the near future – many of these firms may pay for their short-term thinking.
So don’t be surprised if the high-yield bond market (the junk market) begins choking on all these ‘fallen angels’. (The name given to investment grade firms when they’re downgraded to junk).
I know I won’t.
(PS – one thing that will help these BBB-rated firms is if the Federal Reserve ends up cutting rates – which many now expect. So take that into account).
(PSS – I’m not opposed to buying junk bonds. Some offer significant positive asymmetry. But I’ll wait first until the next downturn when they’re greatly discounted – and only then). . .