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Risky corporate debt continues to grow rapidly

16 Mar 2014 by Jim Fickett.

There is more risky corporate debt outstanding now than before the last crisis, and the total continues to expand rapidly. The highest growth rate is in variable-rate loans, which could provide a trigger for defaults as rates rise.

Fitch Ratings recently released an interesting report on junk bonds and leveraged loans in the US, titled, Fitch U.S. Leveraged Loan Default Insight. As the title indicates, the report includes an in-depth study on loan defaults over the financial cycle. Here I will only mention a few simple facts on the growth of risky debt.

Here is the key result:

Note that although junk bonds outstanding exceed institutional (i.e. sold to money managers rather than to banks) leveraged loans outstanding, the loans are growing much more rapidly. This is because most loans are variable rate and, now that the Fed has started to taper, people are beginning to acknowledge that rates won't stay low forever. As Fitch says,

The institutional loan market expanded at a substantially faster clip than the high yield bond market in 2013 ― up 26% year over year (to $725 billion) versus 12% for high yield ($1.265 trillion). Momentum has continued into 2014 with outstanding volume reaching $755 billion in February. …

In 2013, the prospect of rising interest rates heightened retail and institutional demand for loans as a floating-rate yield alternative.

Note also that leveraged loans outstanding are approximately where they were before the last crisis, but junk debt outstanding is much higher. And both continue to grow rapidly.

These two categories of risky debt combined reached about $2 trillion at the end of 2013. To get a sense of scale, subprime mortgages outstanding, at the center of the last crisis, also stood at about $2 trillion in 2007 (Comparing subprime corporate and subprime mortgages).

Many commentators point to low current default rates as assurance that nothing dangerous is afoot. But default rates in 2007 were also very low; default rates are a lagging indicator, not a leading one. Low default rates in 2007 were a primary reason why few understood at the beginning of the crisis that something really serious was happening. Do not make that mistake in the next crisis.

Since the highest growth rate is now in variable-rate loans, as rates rise companies already on the edge will be subject to more strain. And the strain will be contagious to the junk bond market, since many companies have issued both kinds of debt:

Approximately 40% of institutional loan volume is associated with companies that have both loans and high yield bonds in their capital structure. … Since 2007, 56% of defaulted leveraged loan volume of $138.7 billion has come from these joint issuers.