The corporate debt bubble is the large increase in corporate bonds, excluding that of financial institutions, following the 2008 financial crisis. Global corporate debt rose from 84% of gross world product in 2009 to 92% in 2019, or about $72 trillion. In the world's eight largest economies—the United States, China, Japan, the United Kingdom, France, Spain, Italy, and Germany—total corporate debt was about $51 trillion in 2019, compared to $34 trillion in 2009. Excluding debt held by financial institutions—which trade debt as mortgages, student loans, and other instruments—the debt owed by non-financial companies in early March 2020 was $13 trillion worldwide, of which about $9.6 trillion was in the U.S.
The corporate bond market historically centered in the United States. The U.S. Federal Reserve noted in November 2019 that leveraged loans, corporate bonds made to companies with poor credit histories or large amounts of existing debt, were the fastest growing asset class, increasing in size by 14.6% in 2018 alone. Total U.S. corporate debt in November 2019 reached a record 47% of the entire U.S. economy. However, corporate borrowing expanded worldwide under the low interest rates of the Great Recession. Two-thirds of global growth in corporate debt occurred in developing countries, in particular China. The value of outstanding Chinese non-financial corporate bonds increased from $69 billion in 2007 to $2 trillion in 2017. In December 2019, Moody's Analytics described Chinese corporate debt as the "biggest threat" to the global economy.
Regulators and investors have raised concern that large amounts of risky corporate debt have created a critical vulnerability for financial markets, in particular mutual funds, during the next recession. Former Fed Chair Janet Yellen has warned that the large amount of corporate debt could "prolong" the next recession and cause corporate bankruptcies. The Institute of International Finance forecast that, in an economic downturn half as severe as the 2008 crisis, $19 trillion in debt would be owed by non-financial firms without the earnings to cover the interest payments, referred to as zombie firms. The McKinsey Global Institute warned in 2018 that the greatest risks would be to emerging markets such as China, India, and Brazil, where 25–30% of bonds had been issued by high-risk companies. As of March 2021, U.S. corporations faced a record $10.5 trillion in debt. On March 31, 2021, the Commercial Paper Funding Facility re-established by the Federal Reserve the previous March ceased purchasing commercial paper.
While trade in corporate bonds typically centered in the U.S., two-thirds of corporate debt growth since 2007 was in developing countries.
Low bond yields led to purchase of riskier bonds
Following the 2008 financial crisis, the Federal Reserve Board lowered short- and long-term interest rates in order to convince investors to move out of interest-bearing assets and match with borrowers seeking capital. The resulting market liquidity was accomplished through two steps: cutting the Fed Funds Rate (thereby influencing the rate banks charge one another for overnight loans), and quantitative easing, whereby the Fed would buy trillions of dollars of not only U.S. Treasury securities, but also toxic assets, effectively creating functioning markets for these assets and reassuring investors. The success of the U.S. Fed in dropping interest rates to historically low levels between 2009 and 2015 and thus preventing illiquid markets from worsening the financial crisis prompted central banks around the world to copy these techniques.
However, the effect of quantitative easing was not limited to the toxic mortgage bonds targeted by central banks, as it effectively reduced the supply of bonds as a class, causing prices for bonds generally to rise and bond yields to lower. For over a decade, the artificially low interest rates and artificially low bond yields, have caused a "mispricing of risk" as investors continually seek out higher yields. As an example, high-yield debt, colloquially known as "junk bonds", has historically yielded 10% or more to compensate investors for the increased risk; in February 2020, the U.S. yield on these bonds dipped to nearly 5%. This indicates that investors flocking to higher yield have bought so much high-yield debt that it has driven the yield below the level needed to compensate for the risk. U.S. corporate bonds held by mutual funds had tripled over the previous decade.
In June 2018, 22% of outstanding U.S. nonfinancial corporate debt was rated "junk", and a further 40% was rated one step above junk at "BBB", so that approximately two-thirds of all corporate debt was from companies at the highest risk of default, in particular retailers who were losing business to online services. The U.S. Fed noted in November 2019 that mutual funds held about one-sixth of outstanding corporate debt, but were acquiring one-fifth of new leveraged corporate loans. The size of high-yield corporate bond mutual funds, which specialize in riskier bonds, had doubled in the decade prior to 2019.
While trade in corporate bonds typically centered in the U.S., two-thirds of corporate debt growth since 2007 was in developing countries. China became one of the largest corporate bond markets in the world, with the value of Chinese corporate bonds increasing from $69 billion in 2007 to $2 trillion at the end of 2017. By mid-2018, total outstanding U.S. corporate debt reached 45% of GDP, which was larger than that seen during the dot-com bubble and subprime mortgage crisis. Noting negative bond yields in Switzerland, the United Kingdom, and the US in August 2019, Bloomberg News stated that effectively paying borrowers to borrow is distorting incentives and misallocating resources, concluding that bonds are on a bubble.
Low interest rates led to increasingly leveraged companies
Companies that do not make enough profit to pay off their debts and are only able to survive by repeatedly refinancing their loans, known as "zombie firms", have been able to turn over their debt because low interest rates increase the willingness of lenders to buy higher yield corporate debt, while the yield they offer on their bonds remains at near-historical lows. In a 2018 study of 14 rich countries, the Bank of International Settlements stated that zombie firms increased from 2% of all firms in the 1980s to 12% in 2016. By March 2020, one-sixth of all publicly traded companies in the U.S. did not make enough profit to cover the interest on their issued debt. In developing countries, high-risk bonds were concentrated in particular industries. In China, one-third of bonds issued by industrial companies and 28% of those issued by real-estate companies are at a higher risk of default, defined as having a times interest earned of 1.5 or less. In Brazil, one-quarter of all corporate bonds at a higher risk of default are in the industrial sector. Fitch stated in December 2019 that the majority of Chinese companies listed on A-share markets, namely the Shanghai Stock Exchange and Shenzhen Stock Exchange, were unable to repay their debt with their operational cash flow and required refinancing.
Bond investing in Europe closely followed the actions of the European Central Bank, in particular the quantitative easing implemented in response to the European debt crisis. In June 2016, the ECB began using its corporate sector purchase programme (CSPP), acquiring 10.4 billion euro in non-financial corporate bonds in the first month of operation, with the explicit purpose of ensuring liquidity in the corporate bond market. News in mid-2019 that the ECB would restart its asset purchase program pushed the iBoxx euro corporate bond index, valued at $1.92 trillion, to record highs. The increased purchases resulted in 42% of European investment-grade corporate debt having a negative yield, as investors effectively paid less risky companies to borrow money.
The Federal Reserve Bank of New York noted in January 2020 that only two U.S. firms had the highest rating of AAA, Johnson & Johnson and Microsoft, while there was an increased number of firms at the lowest-end, called BAA (on the Moody's rating scale) or BBB (on the S&P rating scale). Investment-grade firms, those with a rating between AAA and BAA, were more highly leveraged than the high-yield ("junk") firms. Observing that investors tend to divest bonds that are downgraded to high-yield, the New York Fed stated, "In the current corporate debt landscape, with a greater amount outstanding of BAA-rated corporate debt and higher net leverage of investment-grade debt overall, the possibility of a large volume of corporate bond downgrades poses a financial stability concern."
Examples of leveraged corporate debt transactions include: Halliburton doubled its corporate debt to $11.5 billion between 2012 and 2020; it sold $1 billion in debt in early March 2020 with the explicit purpose of paying off existing debt and has $3.8 billion in debt payments due through 2026. AT&T debt ballooned to $180 billion following its acquisition of Time Warner in 2016. In 2018, Moody's declared AT&T to be "beholden to the health of the capital markets" because of its reliance on continued credit to service its debt load. KKR sold about $1.3 billion of cov-lite debt in 2017 to pay for its buyout of Unilever, despite Moody's rating the offer 4.99 on a scale of 1 to 5, with 5 being the riskiest. Kraft Heinz had its credit rating downgraded to BBB− or "junk" in February 2020 due to low earnings expectations and the firm's determination to use available capital to provide stock dividends rather than pay down debt. That month, Kraft Heinz had $22.9 billion in total debt with only $2.3 billion in cash assets.
Corporations in the United States have used the debt to finance share buybacks, dividends, and mergers & acquisitions that boost share price to a greater extent than before. This has been done in place of long-term business investments and expansions. The U.S. Tax Cuts and Jobs Act of December 2017 offered a tax holiday under the logic that firms would use the extra profits to increase investments. Instead, it vastly increased an existing trend towards share buybacks, which increase the value of the remaining publicly traded shares and contributed to the rise of stock market indexes generally. While the S&P 500 has risen by over 300% from its low in the Great Recession, this rise is driven partly by the selling of corporate debt to purchase stock that becomes more expensive due to the purchases. The cyclically adjusted price-to-earnings ratio for the S&P 500 indicates it is the most overvalued it has been since the dot-com bubble and is around Wall Street crash of 1929 valuations.
The McKinsey Global Institute cautioned in 2018 against excessive alarm, noting that if interest rates rose by 2%, less than 10% of bonds issued in all advanced economies would be at higher risk of default, with the percentage falling to less than 5% of European debt, which is largely issued by AAA-rated companies.
Search for yield results in growth in covenant light bonds