Planning matters

The U.S. Debt Bubble in Five Charts

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  • Post-2008 interest rate compression engineered by global central banks have resulted in a massive accumulation of debt by both sovereign and corporate issuers.
  • U.S. corporate (non-financial) bonds outstanding have grown by 63% to over $6.3 trillion just since 2011.
  • U.S. government debt outstanding has ballooned by 148% to over $15.8 trillion since 2008.

Rising rates will result in significantly higher re-financing costs for maturing U.S. government bonds

Over the next five years, $7 trillion in U.S. government bonds will mature with an (current) average coupon of 2%. With the two to ten-year portion of the yield curve at or near 3%, that would represent (today) a 50% increase in interest expense. Keep in mind in 2017 alone, the government spent $263 billion on interest, and according to the Wall Street Journal, that figure will spike to $915 billion by 2028, a nearly 250% increase.

Exhibit 1: U.S Government Debt Outstanding

Source: Federal Reserve Bank of St. Louis

The corporate debt binge leaves little margin for safety in the next economic downturn

Corporate debt has exploded to the upside having grown to over $6.3 trillion from $3.5 trillion since 2008, an 80% increase. What’s alarming is nearly 50% of all investment grade credit, about $2.5 trillion, is rated “triple-B”, just one tier above “junk bond” status. The blue shaded area in exhibit 2 below highlights the overwhelming supply of debt amassed at junk’s door step.

Exhibit 2: Non-Financial Corporate Debt Outstanding & BBB-Rated Debt Highlighted in Blue

Source: Bloomberg Barclays 

The next downturn will likely fuel a rapid widening in credit spreads

The fall from investment grade to junk status comes with an abrupt increase in funding cost. Exhibits 3 & 3A highlight both nominal yields and yields differentials between investment and non-investment grade bonds. A BBB credit, pari passu, that deteriorates to junk status would see about a 240-basis point increase in funding cost.

 

Source: FactSet

Widening credit spreads impedes economic growth

According to Morgan Stanley, as Baa (equivalent to BBB) credit spreads widen,1 the added funding cost impedes both economic growth and employment conditions,  acting like an increase in the overall Fed Funds (FF) rate. Moreover, they conclude a 100-basis point increase in Baa spreads is equivalent to a 62-basis point rise in the FF rate. Exhibit 4 below highlights the relationship between widening Baa credit spreads and weakness in the unemployment rate. As spreads widen the unemployment rate rises.

Exhibit 4: Widening Credit Spreads Lead to Weaker Labor Market Conditions

Source: Bureau of Labor Statistics, Bloomberg, Morgan Stanley Research 

In a recent report on global financial stability, the International Monetary Fund (IMF) concludes that credit booms led by a rising share of junk bonds were followed by lower cumulative GDP growth of 2 percentage points over the following three years.2

Investors chasing yields have ignited record corporate borrowing

Investors quest for yield have fueled the burgeoning issuance in both corporate debt and leveraged loans. Recently, both the FED and OCC have warned about risky corporate borrowing that has reached record levels while lender safeguards have eroded.3

Exhibit 5 below highlights a new thirty-two year high in corporate debt issuance as a % of GDP. As in past cycles, junk bond defaults tend to rise rapidly, and with a lag, as debt increases relative to GDP. As the stimulus from Trump’s massive tax cuts and increased government spending begin to fade, I expect junk bond default rates to move higher and replicate past cycles.

Exhibit 5: Junk Bond Default Rate vs Non-Financial Corporate Debt as % of GDP

Source: Moody’s Analytics

 

“Americans for a Better Tomorrow, Tomorrow”

— Stephen Colbert, Comedian 

 

In conclusion, a combination of both rising U.S. interest rates and fiscal deficits along with a potentially huge wave of riskier corporate credit provides a backdrop to our next recession, possible by 2020 according to the investment firm Guggenheim Partners.4

So, considering the massive debt build up and societal cost of running up huge budget deficits to largely finance tax cuts ten years into an economic expansion, perhaps Mr. Colbert’s gag is truer as opposed to funny.

 

December 2018

[1] Baa rating, used by Moody’s credit agency, is equivalent to BBB used by Fitch and S&P.

[2] Source: IMF – “When high yield goes boom” – 6.26.2018 / A credit boom is defined as a period of faster than normal growth in credit relative to GDP.

[3] OCC – Office of the Comptroller of the Currency. Bloomberg – 12.3.2018

[4] Guggenheim Partners – “Forecasting the next recession: The yield curve doesn’t lie”, 10.29.2018

 

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