Financial Times

Are corporate bonds a bubble ready to burst?

As global liquidity tightens, corporate bonds in emerging markets look vulnerable. But while a market correction is likely, this growth is not as ominous as it might seem, write Susan Lund and Eckart Windhagen in the Financial Times.

Is growing corporate debt a bubble waiting to burst? Globally, debt of non-financial corporations has grown by $29tn in the ten years since the financial crisis, nearly as much as the growth in government debt.

But while a market correction is likely, this growth is not as ominous as it might seem. Look no further than the bull market in corporate bonds that has emerged over the past decade. The shift to bond financing by companies is a welcome diversification in financial markets, giving large corporations an alternative to bank loans in financing. However, it is also clear that many higher-risk borrowers have tapped the market in the years of ultra-cheap credit. Over the next five years, a record amount of corporate bonds will mature each year, more than $1.5tn annually, and defaults are likely to rise as some companies struggle to repay.

New McKinsey Global Institute research finds that one-quarter of corporate bonds in Brazil, China, and India are from companies that are already at higher risk of default even at today’s low interest rates.

If interest rates were to rise by 200 basis points, that share could rise to as much as 40 per cent. In advanced economies, most corporate borrowers are in good financial shape, but there are pockets of acute vulnerability, for instance, among speculative-grade borrowers, and in certain sectors like energy and retail.

As banks have restructured and repaired their balance sheets in the years since the crisis, the corporate bond market has surged.

The global value of corporate bonds outstanding from non-financial companies has nearly tripled since 2007, to $11.7tn, and has doubled relative to world GDP.

Traditionally, the corporate bond market was centred in the United States, but now companies from the world over had joined in.

But growing sources of risk in the corporate bond market that could be exposed in the next five years as a record $1.6tn to $2.1tn will mature annually between 2018 and 2022. There are three areas to watch.

First, the average quality of borrowers has declined. In the US, 22 per cent of non-financial corporate bonds outstanding are from speculative-grade issuers, or so-called “junk bonds”.

Another 40 per cent are rated BBB, just one notch above junk. In other words, nearly two-thirds of bonds are from companies at higher risk of default.

Among those which are vulnerable could be US retailers that have a very large amount of speculative-grade debt coming due over the next five years, and are already facing declining sales as shoppers go online.

Another potential source of vulnerability could come from soaring corporate debt in developing countries.

These countries have accounted for two-thirds of overall corporate debt growth since 2007 (a departure from the past when advanced economy firms were the largest borrowers).

China is a big part of the story, with corporate bonds outstanding rising from just $69bn in 2007 to $2tn at the end of 2017, making China one of the largest corporate bond markets in the world.

Finally, some of the companies that have been able to issue bonds have fragile finances.

Our research finds that in advanced economies, less than 10 per cent of bonds would be at higher risk of default if rates were to rise by 200 basis points.

In Europe, the share of bonds issued by companies at risk is currently less than 5 per cent in most countries, indicating that only the largest blue-chip companies have issued so far.

This is not an argument for complacency. There are pockets of vulnerability. Even at today’s interest rates, in the US 18 per cent of the value of bonds outstanding in the energy sector, $104bn, is at higher risk of default.

The biggest risks appear to be in emerging markets such as China, India, and Brazil, where, as noted, up to 40 per cent of corporate bonds could be at higher risk of default (defined as issued by companies with an interest coverage ratio below 1.5) if interest rates were to rise by 200 basis points.

Some sectors are more vulnerable than others. In China, one-third of bonds issued by industrial companies and 28 per cent of those issued by real estate companies are at higher risk of default. In Brazil, one-quarter of all corporate bonds at higher risk of default are in the industrial sector.

The global corporate default rate on financial obligations is already above the 30-year average, and we expect that it may rise further over the next several years given the risks above.

Is the next global financial crisis at hand? We do not think so. Unlike the subprime mortgages that sparked the previous financial crisis, defaults in the corporate bond market are unlikely to have significant ripple effects across the system.

While mortgages were packaged into securitised assets and multiple layers of synthetic securities were built upon them, the same is not true of corporate bonds. Losses will therefore be sustained by the direct bond owners, but the systemic risks seen in the previous crisis are minimal.

Beyond the near-term bumps in the road, the shift to bond financing by companies is welcome, and there is plenty of room for further sustainable growth.

This shift will require banks to focus on new customer segments, such as small and medium-sized businesses and consumers and households.

Investors will have new opportunities for portfolio diversification. Regulators and policymakers should act to encourage transparency and shifting to electronic trading in the bond market, even as they continue to monitor potential risks.

This article appeared first in Financial Times.

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