Image for Corporate Debt Bubble Could Deepen Eventual Economic Recession

An unnoticed economic statistic could pose unforeseen risks in the next recession. Corporate debt has soared to nearly $10 trillion, accounting for 47 percent of the overall economy.

Corporate debt as it relates to GDP is the highest level in recorded history. Half of that corporate debt is in low-grade bonds, just a nudge above junk bonds. 

As The Washington Post reported, “The danger isn’t immediate. But some regulators and investors say the borrowing has gone on too long and could send financial markets plunging when the next recession hits, dealing the real economy a blow at a time when it already would be wobbling.”

Warnings have come from the Federal Reserve, International Monetary Fund and major institutional investors. The manufacturing sector is sending its own warning as new orders, production and hiring all dropped for the fourth straight month. Export orders fell in November after rising in October, reflecting the impact of continuing trade wars and a weakening global economy.

In a potential echo of the mortgage crisis, there has been “sharp growth in lower-quality corporate bonds, just one notch above junk,” Washpo reported. “Investors hold nearly $4 trillion in these bonds, including $2.5 trillion from US companies, according to the credit rating agency Standard & Poor’s.” The so-called BBB bonds were compared to an “unexploded bomb” by Emre Tiftik, a debt specialist at the Institute of International Finance. 

The dire outlook about corporate debt comes as other economic markers are bright. The US economy is growing at a 2.1 percent annual rate, which is consistent with the 2.2. percent average since the last recession. Unemployment remains low, incomes are nudging up and consumer confidence heading into the holiday season seems upbeat. 

Corporations have responded to the economic signal of low interest rates, and some economists believe those low rates could have side effects. Lowering interest rates is a proven strategy to rebound from a recession by stimulating new investment. Raising rates is a strategy to restrain inflation when an economy overheats. The connection between interest rates and inflation in recent time has become befuddled.

While the Fed is an independent agency, it has appeared to bend to calls by President Trump, who has an affection for debt-financing, to cut interest rates to add more juice to the economy and reach the ambitious growth targets he has touted as a result of his tax cut. 

The IMF reported companies have splurged to repurchase their own shares, increase dividends and fund acquisitions. Standard & Poor’s estimates corporations spent $3 trillion over the past five years on stock buy-backs. Hasbro issued $2.4 billion in bonds with low interest rates to pay for the acquisition of a UK entertainment company, increasing the toymaker’s total debt up by 60 percent, according to Bloomberg.

“An artificial environment of near-free money is masking serious underlying ailments and may be storing up problems for a future reckoning,” says Mohamed El-Erian, chief economic adviser to Allianz, the German financial services giant. “This era of perpetually cheap money has kept alive some debt-ridden ‘zombie’ companies that would have failed if rates were at traditional levels, widened the wealth gap between rich and poor and distorted financial decisions.”

In the current environment, lower-rated companies are borrowing at comparable rates to financially sound corporations. If the economy begins to sour, those bonds could be downgraded into ‘fallen angels,’ leading mutual funds and insurance companies to unload them and inadvertently accelerate recessionary pressures.

“In a flash, as all those fallen angels fall into junk territory, there would be too much speculative-grade debt for the market to absorb,” Washpo says. “Companies that already would see profits shrivel from the downturn would suddenly face higher interest rates, chilling investment, forcing layoffs and spreading pain throughout the economy.”

Robert Kaplan, president of the Federal Reserve Bank in Dallas, predicts it could only take a handful of investment downgrades to “depress an already sluggish economy.”