The International Monetary Fund (IMF) released a few enlightening charts in its Global Financial Stability report. The fertilizer for a debt bubble is in place which is why it has grown so large. There is a toxic combination of low interest rates and low growth. Low interest rates encourage borrowing and makes saving less appealing when the return on holding your money with the bank is a fraction of 1% over a prolonged period of time in checking/savings and other similar instruments. Therefore, this pushes people to search for a higher return on investment, which leads everyone into the stock market. By its very nature, stocks (equity) is among the most riskiest forms of ownership. As such with high risks comes the potential for high yield. However, as every investor buys up stocks, this increases the stock price. As the stock price increases, so does the risk of investment as your costs are now higher. This in itself reduces the potential for capital gains as prices are driven higher not by the growth in the company’s business, but via demand from investors for the company’s stock. The stock market has been doing well because of the corporate debt bubble which funds share repurchases. Low growth has encouraged the financialization of the economy as firms can issue bonds at low interest rates to fund company stock buybacks where the company buys its own stock, which artificially increases earnings per share metrics since there are now less shares available for the public to purchase (outstanding) as a result of the buyback.
The chart below is the best representation of the financialization of the economy as leveraged-loan sales (high risk loans) set a new quarterly record. During the tech bubble of the late 1990s these sales barely existed. In Q1 there was $434 billion in leveraged loans (high risk loans) which hungry for yield investors purchased in a low interest rate environment. The latest spike has come despite the rising fed funds interest rate because of anticipated Federal Reserve rate hikes. These rate hikes are spurring repricing loans which represented about half the loan volume in Q1.
The artificially low interest rates on government debt and increased investor demand for yield has pushed junk bond prices higher and rates lower than they otherwise would be. This process is called going up the risk curve. If the low risk investments aren’t providing a decent return, more risk needs to be taken. You may question why an investor would take more risk, but you must look at the scenario from the investor’s perspective. It is risky to accept low risk and low return investments because returns will fail to meet goals which may involve covering for retirement, for example. Opportunity cost is painful when very little profits are made over the long-term. It’s also worth noting that investors aren’t concerned with losing money because of recency bias. This is when recent returns are expected to continue even though past results don’t predict future outcomes. A better way to review trajectory of growth or decline is with rate of change.
One way of proving that junk bonds are too expensive is shown in the charts below.
This chart shows that the average interest coverage ratio is declining, but junk bond yields aren’t rising to make up for that added risk. To be clear, the interest coverage ratio measures how well firms can afford to pay the interest on their debt. It is typically calculated by dividing the EBIT (earnings before interest and taxes) by the interest expense.
As is shown in the chart below, the corporate debt level is getting out of control. It shows the ratio of Net Debt to EBITDA which is one way of measuring leverage. The reason the mean leverage was especially high in the late 1990s and early 2000s is because the bubble was focused in one sector: technology.
This time the bubble is broader based, affecting stocks, bonds and real estate, which is why the median corporate leverage ratio is near its record peak. This is disconcerting because the growth of the past decade is fueled by debt, not savings, which means its sustainability is much more troublesome. A recession will squash the EBITDA which will send the leverage ratio higher, likely to a new record high.
All that debt is being fueled by low interest rates. The question many investors have is what will happen when interest rates rise. That is answered in the chart below which forecasts the average interest coverage ratio if financing costs increase.
If this trend continues to plays out, the interest coverage ratio of the average firm will be lower than the worst of the financial crisis in 2008. Keep in mind, this assumption doesn’t price in a recession where earnings crash. If a recession is combined with rising rates (known as stagflation) the interest coverage ratio will fall below the lows of 2001 and a massive flood of bankruptcies will occur.
The chart below shows where the bankruptcies are likely to occur.
The smallest firms are the most vulnerable because financialization helps large firms at the behest of small ones. Large firms can issue massive bonds at low yields which lets them buyback their stock or make acquisitions. When large firms make acquisitions, they buy the top performers which means the surviving smaller firms are the weakest ones. The weakest ones then must compete with large firms which have more market share than ever because of these acquisitions.
The chart below shows the sector breakdown of the firms which are considered challenged because they have interest coverage ratios below two.
As you can see, consumer discretionary firms aren’t a large portion of the challenged firms even with the recent demise of brick and mortar stores. The sector with the largest amount of challenged firms is energy. This is because of the decline in oil prices which still haven’t recovered to the price they were at before the 2014 and 2015 crash.
The final chart shows the size of the bubble by looking at the size of firms which are weak and vulnerable based on their interest coverage ratio.
20.1% of firms’ total assets are currently weak or vulnerable. That number spikes to 22.1% of firms’ total assets if interest rates rise. If a recession occurs, that percentage may exceed the peak seen in 2001.
The IMF is an intergovernmental agency which means it will generally have a bias towards stability. The IMF doesn’t employ short sellers who are betting against the system, so it is not motivated to predict a crisis. This is what makes these charts look even worse than they are.
The upcoming decline of the corporate debt bubble will make the upcoming recession likely worse than the prior two bubbles of 2000 and 2008. In terms of stock market losses, it will likely be more expansive because the expensive valuations aren’t in one sector like during the 1990s tech bubble. In terms of the economy, it will also be worse because the government debt as a percentage of GDP is larger than before which makes funding fiscal stimulus more difficult.
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