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Impact of rising rates on US corporate debt

In its most recent Global Financial Stability Report (GFSR), dated April 2018, the International Monetary Fund (IMF) warns that banks and investors may be lending too much to risky corporate borrowers, leading to the possibility of defaults and a burst “corporate debt bubble” in the US. The GFSR refers to “the riskiness of corporate credit allocation, given concerns that the continued search for higher yield may have led banks and investors to extend too much credit to risky borrowers.” So how big is the corporate debt bubble and how could this play out?

Bonds in the US's domestic debt market are now worth around $41 trillion, a value that has increased significantly in the past decade. According to data from the McKinsey Global Institute, the value of corporate bonds outstanding in the US was 25 per cent of GDP in 2017, having risen by $2.6 trillion from 16 per cent of GDP since 2007. The unprecedented low interest-rate period has, in short, given corporates a decade of opportunity to “load up on debt”.

Increase in corporate defaults

The problem, as interest rates are now set to rise, is that some bonds are being mispriced. This concern has been expressed by many US bond market observers, including JPMorgan's Jamie Dimon. It's a view echoed by former investment banker and author, William D. Cohan, who argues in this New York Times article that the pricing of bonds (and therefore corporate loans) are not reflecting the risk of the underlying credit, which means that investors are taking on more risk than they can handle.

Cohan adds that “as interest rates continue to rise, and some companies and other borrowers fail to meet their debt obligations, defaults will inevitably increase along with the spreads.” He warns that, when this happens, trillions of dollars in invested capital could be lost. This could trigger another financial crisis, although that may not be imminent. But he warns that, when it does happen, the corporate debt bubble “inevitably will play a role in causing it”.

Distress for individual companies

Some analysts remain sanguine about the prospect of a full-blown crisis. Susan Lund, a partner at McKinsey, told the New York Times earlier this month that she doesn't see the rise in debt as a likely cause of a macroeconomic crisis, although it could cause distress for individual companies. Lund is quoted by the newspaper as saying: “I think there will be a rise in defaults, but I’m not alarmed. I don’t see systemic interlinkages.”


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Financing
Financing Short-Medium Term Deficits
Risk Management
Financial Risk Management

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