When the global financial crisis hit in 2007, it was easy to blame Americans for their reckless mortgage binge. Their median wages had barely budged since the late 1970s, and yet here they were, buying McMansions they couldn’t afford, living beyond their means.
How things have changed. US households have patched up their balance sheets, slashing their debt payments from more than 13% of take-home pay in 2007 to less than 10% today. That’s the lowest number since the US Federal Reserve records began, in 1980. For American households, this is unprecedented, says Ellen Zentner, chief economist at Morgan Stanley.
“I can spend hours talking about the consumer balance sheet—we’ve never seen anything like this. That’s why we’re convinced that [the next recession] is not going to be caused by households this time,” she says. So what, then, is a likelier candidate? “What was it Deep Throat said? Follow the money,” says Zentner. “I would say follow the leverage.”
This trail of excessive borrowing leads beneath the veneer of stable US growth, to the corporate debt market, where a fast-expanding pocket of companies have taken on hefty sums of cheap debt to fund increasingly risky investments. When a downturn hits, the sector’s unusually high leverage means many companies will struggle to make their debt payments as income falls—which could send shockwaves through the whole economy. That’s why Zentner and her Morgan Stanley colleagues put the corporate sector at the top of the list of potential culprits for tipping America into its next recession.
US household debt is at a low point
US households are in a relatively good position—debt-wise, at least—to withstand the next recession. This is a little surprising given that after the 2008 crisis, the central bank made every effort to get Americans spending again.
The US Federal Reserve (the Fed) dropped interest rates to zero in hopes of encouraging households and firms to start investing again. And when that wasn’t enough of an inducement, it launched quantitative easing, buying securities like government bonds in an effort to make borrowing even cheaper by increasing the money supply.
But American families didn’t take the bait. Instead of borrowing more, they have spent the post-crisis years lessening their debt burdens, closing out 2018 with mortgage balances of about $9.5 trillion—nearly 16% less than they owed at the 2008 peak, adjusting for inflation. Here’s another way of looking at it: By late 2007 and early 2008, households had racked up debt equal to a whopping 124% of their after-tax income, according to data from the Fed and the Bureau of Economic Analysis. They have since shrunk that burden by more than a quarter: At the end of 2018, the share stood at 91%—the lowest it’s been since 2001.
One reason household financial health is so important is that personal consumption drives more than two-thirds of the US economy. The vastly reduced share of household income going to banks and credit card companies has freed up money for consumer spending, helping power America’s unusually strong growth in recent years.
Another improvement in household finances comes from the kind of debt owed. Mortgages make up around two-thirds of the total debt owed by households. When the interest rate on those loans are fixed for a long period of time, the monthly payments are stable and predictable. Not so for adjustable-rate mortgages; because these rise and fall with market rates, families that take them out can face a sudden sharp jump in the amount they owe each month. And that ups the risk of financial strain. Back in 2007, as the US housing market boom was turning to bust, one out of every five mortgages was adjustable rate, according to Morgan Stanley’s Zentner—compared with one in 10 today.
Both the extra spending power created by smaller debts and the constant mortgage rates have helped put US household balance sheets in a better position to weather a downturn. But for corporations, it’s a different story entirely.
From the post-crisis recovery, a new bubble grows
American companies came through the 2007-2008 crisis in much better shape than did households. Though they too had borrowed a lot in the heady days of the mid-2000s, US corporate debt peaked in 2008 at only 72% of US GDP—much less than the 99% of GDP borrowed by families, according to data from the Bank for International Settlements (BIS). And initially, US companies reacted to the Great Recession in the same way as households, diligently reducing their debt.
However, starting around 2012, as the US recovery finally gained steam, they put that thrift behind them and started borrowing again. And boy, were investors ever ready for them.
In the wake of the 2007-2008 financial crisis, the Fed had gone to unprecedented lengths to make borrowing money cheap. As a result, the yield (the earnings realized by a bondholder) on US government bonds, the least-risky of investments, fell so low that investors—particularly big institutional investors like pension funds, insurers, and mutual funds—sought returns from corporate debt instead.
The ravenous demand of investors for investments with higher returns meant that companies could borrow money by issuing bonds at incredibly cheap rates. So sell bonds they did. The value of corporate debt issued by US companies totaled $5.5 trillion at the end of the third quarter of 2018, according to Fed data. It stood at just under $3 trillion a decade earlier.
As US households have significantly cut their debt, the debt of US corporations has risen to unprecedented levels.
That alone is worrisome because the more America’s corporate sector depends on debt, the greater the risk that a slowdown or another economic shock sets off a wave of defaults. If that spooks investors and causes a pullback in lending, the effects could ricochet throughout the whole US economy, making the next downturn much harsher—or maybe even causing it.
It’s worse than that, though. Not only is corporate debt much higher than in the past. The quality of that debt is also much, much lower.
The bonds corporations have been issuing are increasingly risky
As the Fed pushed down borrowing costs—and, therefore, returns earned for lending money (which is what’s happening when you buy corporate bonds)—investors were more and more willing to take on risky investments. And companies were happy to take advantage of this demand. As a result, compared to before the Great Recession, bonds issued by companies with shaky prospects now make up a greater share of the overall volume of corporate bonds on the market.
When firms issue corporate bonds, ratings agencies grade them based on default risk and other factors. Different ratings agencies have different taxonomies, but in general, the safest bonds earn AAA ratings, followed by AA, and so on. These ratings are important because they help determine how much interest firms issuing the bonds have to pay in order to borrow. Regulators also use the ratings system to prevent the buildup of risky investments among big institutional bond-buyers like pension funds, insurers, and, increasingly, mutual funds. These rules require bond funds to hold a certain share of their portfolio in “investment grade” bonds. That includes the highest-rated bonds; anything below that is deemed “high-yield” (or, as it’s less euphemistically known, “junk”). And the cutoff for investment grade is BBB-.
After the recession, two types of not-great debt have become more prevalent:
- Almost-junk bonds: Investors’ exposure to not-quite-junk debt—that rated BBB, just above the investment-grade threshold—is bigger than ever. At face value, BBB debt is as of October 2018 worth around $2.5 trillion, according to Morgan Stanley—more than thrice what it was in 2009. Growth in less risky bond issuance hasn’t grown as fast, and now BBB debt makes up more than half of the investment grade index’s value, compared with only 27% in the early 2000s. This is especially disquieting because amid the big BBB bond bonanza, overall credit quality has slipped too. Firms whose excessive borrowing would have in the past disqualified them from the BBB rating have in the last few years been making the cut. If ratings were based only on debt levels, according to Morgan Stanley some 45% of the BBB bonds in the investment-grade index would earn a junk rating—versus only 8% in 2011.
- Leveraged loans: BBB debt isn’t America’s only—or even its ugliest—debt problem. The mushrooming market for so-called leveraged loans is especially ominous. This term refers to credit extended, usually by a syndicate of banks, to companies that are already heavily indebted or have unusually weak credit ratings, compared with industry norms. More than half of the share of issuances go to companies whose that already owe debt worth five or more times their annual earnings. Note that these differ from normal bank loans in part because they are securitized, and therefore, can be held by institutional investors. Estimates of the volume of leveraged loans outstanding vary (and because these are shadier instruments, market data are harder to compile). By the Fed’s tally (pdf), leveraged loans outstanding exceeded $1 trillion by late 2018. In a November 2018 analysis, Tobias Adrian, an International Monetary Fund economist who specializes in analyzing financial dynamics, recently estimated that institutions like mutual funds and insurance companies hold about $1.1 trillion of US leveraged loans. As with BBB bonds, underwriting standards for leveraged loans have eroded, upping the risk of investors getting stuck swallowing big losses.
How debt becomes a systemic risk
When firms are more dependent on debt—rather than earnings—to fund their operations, an event or change in the economy that suddenly makes it harder for them to borrow is much likelier to throw their businesses into tailspin—or even cause them to default.
What kind of event or change? Fed rate hikes, for one. As borrowing costs rise, heavily indebted companies will find it harder to cover existing debts—setting off a wave of downgrades (when ratings agencies drop a bond’s grade). When companies are downgraded, their lowered credit rating usually means they have to pay more to borrow (i.e. pay investors a higher yield to buy their debt).
In the past three decades, rising borrowing costs tended to precede a wave of downgrades, which in turn gave way to a spate of defaults. Right now, investors don’t seem all that concerned about those things. But the process by which borrowing costs rise can be sudden and self-reinforcing—in some ways, even, self-fulfilling. For instance, the mere fear that something like an imminent rash of downgrades will make it harder for companies to pay back their debt could prompt investors to pull back funds. Since ratings agencies downgrade companies that face a greater risk of missing payments, the resulting jump in borrowing costs could lead to a mass downgrade of debt.
But this time around, there’s another force that could amplify this dynamic: how the current owners of BBB-rated debt react to downgrades.
The ticking time bomb in mutual funds
Fed governors don’t usually talk much about the seamier patches of the corporate bond market. But in a recent pair of speeches, Fed governor Lael Brainard broke with precedent. And perhaps her biggest source of concern was mutual fund holdings of those just-barely-not-junk BBB bonds.
Brainard noted that mutual bond funds have doubled in size over the last decade, with $2.3 trillion of assets under management at latest count. That means mutual funds control about one-tenth of the US corporate bond market.
Here’s the rub. Remember, compared to the past, an unusually high share of the investment-grade index is made up of BBB-rated bonds—and that a disproportionate share of those are debt issues from companies whose finances are a little on the shaky side. Meanwhile, mutual funds currently own a lot of investment-grade bonds, and are all bound by roughly the same rules that limit how much junk they can hold.
Now, imagine a slowing economy, for example, triggers a wave of downgrades of BBB-rated corporate bonds. All at once, mutual funds will be forced to sell the newly downgraded bonds to comply with regulations. Finding buyers for this sudden glut of newly christened junk bonds will be hard.
This isn’t pure speculation. As a recent report by the Organisation for Economic Co-operation and Development (OECD) notes, between 2001 and 2005, downgrades from investment grade to junk triggered “fire sales” by insurance companies (along with mutual and pension funds, insurers are the other big institutional buyer of corporate debt). That pushed yields up unusually high, forcing the companies whose debt was downgraded to pay rates many times higher on new debt. To turn to another example, in the mid-2000s, General Motors and Ford had racked up so much outstanding debt that ratings agencies in May 2005 hit with automakers with downgrades from investment-grade to junk, according to the OECD report. Borrowing costs leapt by two percentage points, and remained higher, months later.
In fact, according to Morgan Stanley research, we’ve seen three corporate bond downgrade cycles a few times in the last 30 or so years: in 1989-1991, 2000-2003, and 2007-2009. Each lasted between two and four years and coincided with a recession. Somewhere between 7% and 15% of the investment-grade bond index was downgraded to junk during those cycles. Once you account for the increased share of BBB debt, that works out to downgrades worth between $550 billion and $1.1 trillion.
The BBB-bond downgrade risk isn’t the only potential corporate debt time bomb that could push borrowing costs suddenly higher, though. Another, says Morgan Stanley’s Zentner, is the rollover schedule.
When a bond matures, firms often “roll over” the debt, reissuing the bond instead of paying back the principal. Now, the rates of most corporate bonds are fixed (that is, once a company sells bonds to investors at the agreed-upon interest rate, the price of the bond might change as investors trade the security, but the debtor company continues to pay the set rate until the bond at last comes due). But each time they roll over their maturing debt, that rate can change (or, alternatively, investors can demand payment of the principal). Each time a rollover happens, it creates an opportunity for investors and corporations to settle on a new cost of borrowing. And those rates influence each other. A higher frequency of rollovers means more chances for borrowing costs to shift abruptly throughout the market.
Last year, the volume of corporate bonds rolled over hit record levels. For investment-grade bonds, the volume of rollovers will continue to rise, peaking in 2021. Junk bond rollovers, meanwhile, will rise at a much sharper rate through 2023.
The problem is, the dodgy corporate debt isn’t a concern only for mutual funds and insurers. The corporate bond market tends to influence borrowing costs for the whole economy.
So what does all this mean for the next recession?
Long-standing American tradition holds that households set off recessions. One reason is that their cumulative balance sheet is mammoth, and in the past, much of that was exposed to variable interest rates. So when inflation started to pick up and the Fed raised interest rates too rapidly in response, households watched their monthly interest payments jump. That, in turn, ate into disposable income and induced a knee-jerk pullback in consumer spending. As demand dropped, companies back-burnered investment plans and, as the feedback loop built, start laying off workers.
This time, though, is likely to turn that trend on its head.
As rates on corporate debt increase, the impact is likely to be much broader than just corporate bond markets, says Zenter. “Even if that default cycle is contained to one particular low-quality segment of corporate debt, it tends to have a gravitational pull on credit spreads everywhere,” she says. In other words, say only a small share of BBB-rated corporate debt gets downgraded. That could very well drive up borrowing costs throughout the bond market—and exacerbate the slowdown hitting the rest of the economy. How could that be?
“So as rising wages are pressuring margins, wider corporate credit spreads [i.e. higher borrowing costs] will be raising the cost of capital and raising the need for businesses to cut expenses elsewhere,” she says. “And the most meaningful expense you can cut is labor.”
That isn’t to say the next downgrade cycle, followed by a wave of corporate bond defaults, would automatically trigger a recession. It all depends on how other markets and borrowing costs in general affect the real economy—especially jobs. However, Zentner’s research shows that rising borrowing costs for corporations can have a direct impact on driving up unemployment.
The timing is impossible to predict, of course, but this probably won’t happen tomorrow, or even necessarily any time soon. Thanks to buoyant 2018 and corporate tax cuts, balance sheets are in slightly better shape than they were a couple years ago. Borrowing costs for corporations are still unusually low by historical standards, suggesting that investors aren’t too worried about looming risks. And why would they be? Default rates are still pretty low.
Still, the staggering amount of borrowing by US companies ups the chance that the US will be mired in a recession that lasts longer than a normal recession would have. It could contribute to what economists call a “balance sheet recession,” in which companies use money that could have been spent on investments that stimulate the economy to back debts instead.
Despite the relative health of the US economy, the United States has already pulled the traditional levers for bringing the economy out of a recession. Interest rates are low, and the Trump administration has already deployed much of its fiscal stimulus ammunition. That means unlike last time, companies won’t be able to count on much help from monetary and fiscal authorities.
As it turns out, the one factor strong enough to offset a corporate balance sheet recession just so happens to be the villains of 2008. After a decade of cleaning up their finances, American families are now the new model of pecuniary prudence—and hopefully a new pillar of American economic stability, too. If the next recession winds up shallower than expected, headlines will likely be starkly different from last recession: instead of blaming US households, it may finally be time to thank them.