Busy atmosphere during the launch of the Kanye West temporary PABLO London store

Investors jumped on junk bonds like they were t-shirts at a Kanye West pop-up store. (Photo by John Phillips/Stringer/Getty Images)

Features | From Pivot Magazine

Heap of junk

The real debt crisis may be the surge in low-quality corporate bond

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Overvalued home prices and high household debt levels are the economic issues most worrying Canadians today. However, it might surprise you to know that personal debt is not the only debt problem we face—in fact, it may not even be the most serious. That title goes to corporate debt, which has been growing at an alarming rate.

Roughly 10 years of emergency lows in interest rates have kept the yield on safe assets like government bonds at extremely low levels, forcing investors into a continuous search for higher returns elsewhere. This has been a boon to businesses—yields on corporate bonds sat near record lows relative to government bonds for years, having made it extraordinarily cheap to increase leverage in the last decade.

And businesses have been more than happy to oblige. Data from public filings shows that gross issuance of corporate bonds has hit fresh records nearly every year in Canada since 2010. Last year, corporations issued a record $273 billion in bonds, and this year is on track to top that. Average issuance in the last five years was double that of the previous five, and corporate debt-to-GDP is at an all-time high.

Under normal circumstances, this would be a worrying trend, but probably wouldn’t signal an imminent threat. Higher issuance is the logical reaction to lower borrowing costs. But there has also been a notable shift within the corporate bond sector toward riskier issuers. Sales of high-yield bonds, also called junk bonds, hit a record of more than $3 billion in 2017, eclipsing a market that normally averages sales in the hundreds of millions. 

Sales of high-yield bonds, also called junk bonds, hit a record of more than $3 billion in 2017, eclipsing a market that normally averages sales in the hundreds of millions

A rising interest rate environment, like the one we’re now in, would normally signal tougher times ahead for corporations issuing debt. Indeed, the yield spread between higher-rated, investment-grade corporate bonds and government bonds has actually widened in the last six months. Recall that bond yields move inversely with prices—the higher the price, the lower the yield and vice versa. The spread between corporate and government bonds, therefore, is the relative price between the two instruments—a rising spread is therefore an indication that investors are less likely, relatively, to buy into corporate bonds. This can be a reflection of a number of things, but typically signifies growing vulnerability within the corporate sector.

And the lower the credit quality, the greater the vulnerability. 

Based on these facts, one might assume then that creditors would be less willing to absorb a dramatic increase in junk issuance. Yet, investors jumped on those bonds like they were T-shirts at a Kanye West pop-up store.

The spread between junk bonds and government bonds has actually continued to narrow in the past year, thanks to investors bidding up bond prices. This is completely counterintuitive when you consider the default risk, but completely intuitive if you consider the return. And that relationship is clear: in a rising rate environment, the higher the credit rating, the worse the return. Investors are looking for yield, and they don’t care where they have to go to get it.

But junk bonds are junk for a reason—their default risk is higher because they are inherently more vulnerable than their higher-grade counterparts, and the fact that yield spreads are counterintuitively narrowing suggests that investors may be mispricing that risk.

Junk bonds are not the only thing we need to be worried about. Perhaps even more disconcertingly, it’s not like things are that much better on the investment-grade side of things either. 

BBBs are somewhat unique when it comes to how we think about risk, especially today.

A recent Bank of Canada analysis showed that investment-grade issuance has notably migrated toward the lower ratings (BBB being the lowest, AAA being the highest). In the U.S., this issue is downright stark—BBB-rated bonds alone make up nearly half of the investment-grade universe and, in dollar terms, are more than double the size of the junk bond market. 

BBBs are somewhat unique when it comes to how we think about risk, especially today—they benefit from significantly lower debt costs by being considered “investment grade,” yet most are just one or two downgrades away from being considered junk. And there’s nothing like rising interest rates, trade disputes, political tensions and the other economic risks we currently face to put the sustainability of one’s finances under the microscope by credit rating agencies. 

Should any event, external or otherwise, trigger a slowdown in growth or in any way cause rating agencies to doubt the outlook for corporates in North America, then many of those companies may see themselves being downgraded from investment grade to junk. It would be like waking up and finding out you were simultaneously a subprime borrower and that your mortgage was up for renewal. What rate do you think you’d get?

If individual corporations lose access to wholesale markets, the risk is that they then start to cut investment spending, shed jobs, or both. This, in turn, could cause a deterioration in other businesses’ outlooks, potentially triggering a domino effect that would hinder the wider economy. The risk of that happening in Canada is not yet at brace-for-impact level, but the situation is heading in that direction.

So while it might be instinctual, at this point, to worry at the thought of record household debt levels, just remember that households may not be the straw that breaks the camel’s back. It might be all the junk we put up there.