Keeping an Eye on Heavy Corporate Debt
The opportunity to borrow at low interest rates has enticed corporations to issue more than $1.0 trillion in bonds every year since 2010. By the end of 2018, corporate balance sheets were carrying $9.1 trillion in debt, up from $5.5 trillion in 2008.1 As a result, corporate leverage amounts to about 46% of U.S. gross domestic product (GDP), matching levels reached during the last financial crisis.2
Corporations sell bonds to finance operations and capital investment. In recent years, more companies have used debt to fund costly acquisitions that may or may not improve future profit margins or growth prospects.3
Now that interest rates are on the upswing, one big-picture concern for investors is whether heavy corporate debt will become a threat to the U.S. economy. If you rely on corporate bonds for retirement income or to help temper the effects of stock market volatility, you might also consider the potential impact on your fixed-income portfolio.
The ABCs of Risk and Ratings
Corporate bonds usually offer higher interest rates than U.S. Treasury securities with comparable maturities. Whereas Treasuries are guaranteed by the federal government as to the timely payment of principal and interest, corporate bonds are not guaranteed and depend on the financial strength of the issuing company.
Most corporate bonds are evaluated for credit quality by one or more ratings agencies, each of which assigns a rating based on its assessment of the issuer’s ability to pay the interest and principal as scheduled. Investment-grade bonds are generally rated BBB or higher by Standard & Poor’s and Fitch Ratings, and Baa or higher by Moody’s Investors Service. Non-investment-grade bonds (also called high-yield or “junk” bonds) are issued by companies that pose a greater risk of default. Bond investors generally expect a higher interest rate as compensation for bearing the additional risk.
Many factors can alter a company’s perceived credit risk, including shifts in economic or market conditions, adjustments to taxes or regulations, and changes in management or projected earnings. When a ratings agency upgrades or downgrades a company’s credit rating, or even adjusts the outlook, it often causes the prices of outstanding bonds to fluctuate.
Anticipating Fallen Angels
Some companies have taken advantage of very low rates and favorable terms, putting them in good shape to repay their debt over a long period of time. But those that must refinance their maturing debt will likely face higher borrowing costs, and struggling firms might find it difficult to access credit.
Many companies have borrowed as much as possible without incurring a junk rating, resulting in a surge of debt issuance at the lowest rungs of the investment-grade ladder. At the end of 2018, more than 50% of U.S. corporate bonds were rated in the BBB tier — one step above junk — compared with about 34% a decade ago.4
Debt payments should remain manageable as long as the economy and corporate earnings are growing. But heavy debt loads may be harder to carry in the next downturn, and an unprecedented number of bonds could be downgraded to junk.5
Bonds that lose their investment-grade ratings are known as fallen angels, and they are immediately removed from the investment-grade indexes that track them. Bond funds that are required to keep only investment-grade bonds in their portfolios may have to sell junk-rated bonds at steep discounts, which could push down fund prices.
Performance Under Pressure
As a category, U.S. investment-grade corporate bonds posted a loss of about 2.5% in 2018, making it the worst year for returns since 2008. Concerns about the deteriorating credit quality of bonds issued by some well-known companies were partly to blame.6 And rising interest rates placed downward pressure on fixed-income investments in general.
Corporate bonds overall are lower quality and appear to carry more risk than they have in the past. However, a recent report by Fitch Ratings contends that the rise in BBB-rated bonds may not produce the feared wave of fallen angels in the next downturn. Many companies with low investment-grade ratings also have the financial flexibility to maintain their credit ratings by reducing dividends and other payouts to investors.7
And while the U.S. economy may be slowing a bit, it doesn’t seem to be speeding toward a recession. The Federal Reserve’s latest forecast for 2019 GDP growth was 2.3%, down from an estimated growth of around 3.0% for 2018.8
Some companies and industries are more heavily indebted and/or may be more vulnerable to business cycle transitions than others. Considering the uncertainty, you may want to take a more cautious and selective approach when evaluating corporate bond investments.
The principal value of bonds may fluctuate with changes in interest rates and market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect bond fund performance.