The coronavirus is threatening the global economy and financial markets. But so is another, less obvious peril — the mountain of risky debt issued by companies and bought by investors during the recent economic expansion.
Paying back this debt is going to be tough for businesses that have issued it if their earnings fall because of the coronavirus. Delinquencies, defaults and investment losses are likely, analysts say, possibly subjecting the economy to what economists call a negative feedback loop.
United States debt levels are at record levels and markets for riskier debt — such as high-yield corporate bonds — have been flashing warning signs. Buyers of riskier debt are also withdrawing from the markets, analysts report. In mid-February, for example, an index of high-yield bonds was up almost 1.2 percent for the month, according to LevFin Insights, an analysis firm. By month end, the index was down 1.5 percent.
We've seen this movie before. In 2008, trillions of dollars in mortgage debt amassed during a huge run-up in residential real estate had to be unwound, contributing to a worldwide recession that was deep and destructive.
This time a different type of debt looms — business borrowings. United States nonfinancial corporate debt outstanding stood at $10.1 trillion in the third quarter of 2019, up from $7.1 trillion in 2013, according to the Federal Reserve Board.
Traditionally, the amount of corporate debt outstanding has been smaller than home mortgage loans, but now the two are neck and neck. For the first time in modern history, commercial loans are the largest group of assets held by banks, surpassing mortgage loans, which had been the top holding.
"Not only has there been a surge in corporate debt, but the quality of the debt is the weakest it's ever been," said David Rosenberg, chief economist at Rosenberg Research, an investment consulting firm. "The last cycle was about the household sector and commercial banks. This is about the business sector and the holders of the spurious debt are mutual funds, insurance companies and hedge funds."
Some features of today's debt binge look a lot like the last one: Before the virus hit, rising stock and bond prices had fed a complacent belief among investors that asset prices could only go up, much like during the residential housing boom that preceded the 2008 crisis. This complacency has resulted in an increased appetite for risk among hedge funds, mutual funds and insurance companies seeking gains in their portfolios.
Congress and financial regulators have also played a part in the current credit bubble as they did in the last, said Joshua Rosner, principal at Graham-Fisher, an independent research consultancy. In 2018, Congress and financial regulators loosened rules, encouraging investors to raise their borrowings. Rules were also relaxed for residential borrowers during the lead-up to the 2008 crisis.
Because businesses have been humming and stock prices rising, debt has not been much of a concern, said Vicki Bryan, founder of Bond Angle, a high-yield bond research firm.
"Debt has been completely ignored — it's like the addictive drug that everybody thinks is OK, until it's not," Bryan told NBC News. Coming into focus now, she added, is the problem of what the companies that issued loads of debt did with the proceeds. Rather than using it to invest in their operations or bolster their financial positions, many chose to buy back their shares or pay dividends to investors.
"It's weakened the system," Bryan said. "It shrinks the margin these companies have for when things go wrong."
According to the Fed, the fastest growing segment of the corporate debt market has been leveraged loans, those made to companies with a poor credit history or high levels of existing debt. These loans totaled $1.1 trillion in 2019, an increase of 15 percent.
In a speech last May, Jerome Powell, the chairman of the Federal Reserve Board, noted that business debt issuance has recently been concentrated in the riskiest segments and layoffs may be a result. "Some businesses may come under severe financial strain if the economy deteriorates," he said in the speech. "A highly leveraged business sector could amplify any economic downturn as companies are forced to lay off workers and cut back on investments."
Mutual funds have been big buyers of corporate debt. Last year, funds held a record $1.53 trillion in corporate loans, up from $504 billion in 2009, according to the Fed.
Heavy investor redemptions could be problematic for these mutual funds, Fed researchers noted in a report last November. "The timing mismatch between the ability of investors in open-end bond and bank loan mutual funds to redeem their shares daily and the longer time often required to sell corporate bonds or loans creates conditions that can lead to runs on these funds in times of stress," the researchers wrote.
Bryan, the bond analyst, agreed. "The high-yield market tends to seize up when something is really bad," she said. "The liquidity you count on in the stock market, that's not a given."
Investors, too, have increased their debt in recent years, using borrowed money to purchase holdings, Federal Reserve data shows. While using debt juices investors' returns as asset prices rise, when they fall, it amplifies losses, requiring managers either to put up additional cash or sell the losing stakes.
Hedge funds like leverage. The most recent Federal Reserve data shows that on average, hedge funds' gross assets, including borrowings, were 7.7 times their net assets in December 2018, up from 5.4 times in 2013. That means for every dollar of outright losses they incur, they're on the hook for $7.70.
Of course, these funds are supposed to hedge their positions, by means such as implementing trades that benefit from a falling market to offset those that profit from a rising one. Offsetting trades like these will provide protection in a rout.
Still, regulatory filings confirm significant debt levels among some hedge funds. As of January, for example, Citadel Advisors had $194 billion invested, counting leverage. Its most recent net assets, meanwhile, were $27.5 billion, translating to approximately seven to one leverage.
A Citadel spokeswoman declined to comment about its leverage.
ExodusPoint Capital is another example. A relatively new hedge fund that oversees $8.7 billion after its 2017 launch, ExodusPoint's leveraged assets stood at $90 billion at the end of 2019, or a roughly 10 to one ratio.
ExodusPoint did not respond to a request for comment.
Deregulation, a favored policy of the Trump administration, has also fed the debt binge. In 2018, regulators and Congress loosened rules governing corporate borrowing, allowing for greater amounts of leverage in the system and increasing the risks associated with these borrowers.
One change took place in the spring of 2018, when Congress passed legislation allowing business development companies, closed-end investment firms that make loans to small and mid-sized entities, to double their maximum allowable leverage. Business development companies with publicly traded shares are popular among investors seeking high yields.
Then, in September 2018, the nation's top banking regulators made a big shift that involved leveraged borrowers.
For years, the three top banking regulators, the Fed, the FDIC and the Comptroller of the Currency, made a practice of identifying "bright-line" thresholds in their supervisory guidance for banks to follow. One such threshold had to do with leveraged lending, with regulators warning banks against lending money to companies that already carried borrowings of more than six times an earnings measure.
But in the fall of 2018, the three regulating agencies said previous thresholds should not, in fact, be viewed as binding by the banks they oversee. That freed up the institutions to lend money to already heavily indebted institutions.
After almost 10 years of economic growth and rising business indebtedness, this was the wrong thing to do at the wrong time, said Rosner of Graham-Fisher & Co. "Regulators have been complicit in supporting leverage in the system to keep the economy growing when they should have been concerned about safety and soundness," he said.