The problem of too much debt in the corporate sector

Investment grade (I-Grade) corporate bonds have experienced an unprecedented decline in market values over the last weeks. US I-Grade corporate bonds are already down 16% for the year (more than stocks and junk bonds) and also European I-Grade bonds show a pullback of investors much larger compared to the 2008-2009 global financial crisis or the Corona crisis (see the FT article documenting this in more detail).

Investors appear to be more concerned with credit risk of corporate borrowers these days. And they should be. The figure below (taken from my research on “Trends in Corporate Borrowing”, published in the Annual Review of Financial Economics in 2021) shows that most of the increase in leverage (proxied by debt issuances in a year) originated in the investment grade corporate bond market since the global financial crisis. The third panel in the picture shows this forcefully.

Worse, a large part of the issuances are driven by BBB-rated borrowers. Edward Altman documents that a large part of these BBB-rated firms are actually much worse than their rating status suggests and that these are likely “zombie” firms. In fact, some of those became fallen angles during the COVID crisis when some of this risk materialized. Ed’s research on “COVID-19 and the Credit Cycle” appeared in the Journal of Credit Risk.

Supply-chains problems already became apparent following the COVID-19 crisis given the also very different national responses to the pandemic. These problems magnified in February 2022 with the start of the Ukraine-Russian war and the economic consequences that increase the risk of a recession in the US and Europe. Investors might thus have become concerned that highly levered (I-Grade) corporates experience problems in meeting their debt repayments and experience possible rollover risk.

I hope this is interesting and please reach out if you have thoughts or questions.