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Dynamite Lurking in the Corporate Bond Market

In a search for profit during a decade of weak sales, buying competitors using cheap debt has been an easy way for large corporations to fuel growth. However, hindsight will likely show that the trend falls in line with late-cycle behavior. According to Bloomberg, out of 50 of the largest corporate acquisitions over the last five years, were it not for leniency of the credit rating agencies coupled with promises to cut costs and pay down the debt, most of the companies would now be facing junk-rated status.

With the surge in acquisitions pushing leverage levels into high-risk status, BBB-tier rated US corporate debt has reached $2.47 trillion, more than three times the amount in 2008. According to strategists at Morgan Stanley nearly $1.1 trillion of the debt is at risk of being rated as junk, leading to the highest level of junk-rated bonds in the last three economic downturns.

It is prudent to consider that massive corporate debt will be one of the factors triggering the next economic downturn. While corporations are currently generating enough cash flow to manage the debt loads, minor shifts, including further interest rate hikes, may have a major impact. Hindsight will likely show that those companies mitigating risk now through deleveraging and shoring up their balance sheets will ultimately prove to be the most robust.

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