LONDON — To grasp why the most important central banks — from the Fed to the Bank of England to the Bank of Japan —- are now leaping into action as if the world were on fire, it helps to examine the subject of corporate debt.
For years, wonks bearing spreadsheets have warned that corporations around the planet were developing a dangerous addiction to debt. Interest rates were so low that borrowing money was essentially free, enticing companies to avail themselves with abandon. Something bad was bound to happen eventually, leaving borrowers struggling to make their debt payments. Lenders would grow agitated, tightening credit for everyone. The world would confront a fresh crisis.
Something bad is now happening. As the coronavirus outbreak spreads, halting factories from China to Italy, sending stock markets plunging and prompting fears of a worldwide recession, historic levels of corporate debt threaten to intensify the economic damage. Companies facing grave debt burdens may be forced to cut costs, laying off workers and scrapping investments, as they seek to avoid default.
“We have been always saying that we are sitting on top of an unexploded bomb, but we don’t know what is going to trigger it,” said Emre Tiftik, director of Research for Global Policy Initiatives at the Institute of International Finance, a Washington-based financial industry trade group. “Can the coronavirus be a trigger? We don’t know. Maybe.”
By the end of 2019, total outstanding debt among corporations other than financial institutions had surged to a record $13.5 trillion worldwide, according to a recent report by Serdar Çelik and Mats Isaksson for the Organization for Economic Cooperation and Development, the Paris-based research institution. That number has swelled as many companies have sold riskier bonds to finance expansions.
Worries about corporate debt appear to be enhancing the panic that has captured world markets, as investors have dumped riskier assets like stocks in favor of safer holdings like United States government bonds.
This was especially vivid on Monday, as markets plunged in reaction to word that Saudi Arabia was driving oil prices lower. Many energy companies are dependent on riskier bonds. For them, lower oil prices translate into lower earnings. They may be forced to cut costs through layoffs or diminished investments to find cash to make their debt payments.
Concern about corporate borrowing also helps explain why the U.S. Federal Reserve last week opted to drop interest rates, and why the European Central Bank is expected to follow suit on Thursday. Lower interest rates limit debt payments for companies that might otherwise fall into trouble.
The concern about the magnitude of corporate debt is an outgrowth of how the world reacted to the financial crisis in 2008. Central banks from the United States to Europe to Japan pushed interest rates to zero and below, spurring companies to borrow and invest.
That approach ended the emergency, but also removed a source of market discipline: It diminished the risk of relying on debt.
Since 2008, corporations worldwide have issued about $1.8 trillion in new bonds each year, a pace roughly double the previous seven years, according to the O.E.C.D. Bond sales slowed in the latter half of 2018, as central banks lifted rates. But as central banks last year lowered rates anew, the debt binge resumed.
The International Monetary Fund last year examined the situation in eight countries including the United States, Japan, China and several European nations. It warned that a shock only half as severe as the global financial crisis would put nearly 40 percent of total corporate debt at risk, meaning that companies would not be able cover their payments with earnings alone.
Not everyone is sounding the alarm. “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years,” said Nicolas Véron, a senior fellow at the Peterson Institute for International Economics in Washington. “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”
In contrast to the financial crisis of 2008, few today are worried about the banking system, which holds capital to cover bad loans. The best-financed companies like Apple, Google and Facebook have hundreds of billions of dollars in cash, making them essentially immune to whatever reckoning may lie ahead.
But even some who praise central banks for rescuing the world from catastrophe argue that easy money has outlived its usefulness. Years of loose credit have enabled weak companies to stave off extinction.
“There are whole sectors that survived that should have gone into restructuring,” said Alberto Gallo, head of macro strategies at Algebris Investments, an asset management firm in London. “Retailers in a world of online retail, energy companies with high production costs, small banks in Europe that are not efficient. The availability of funding at very cheap rates has kept zombie companies alive. This means we have an accumulated level of fragility in the economy which can be exposed very easily to real shocks.”
As the coronavirus has spread from Asia to Europe to North America, it has threatened the earnings of companies that have financed their businesses by selling riskier bonds.
The world of bonds can be roughly divided into two realms — those that gain the stamp of approval from credit rating agencies as investment grade, and those deemed to be less secure, bearing so-called junk status. Since 2010, about one-fifth of new corporate bond issuances have been below investment grade, according to the O.E.C.D. Last year, that proportion grew to one-fourth. “Default rates in a future downturn are likely to be higher than in previous credit cycles,” the report said.
Even within the sturdier category, bond markets have taken a pronounced turn toward risk: Last year, 51 percent of all outstanding investment-grade bonds were rated at BBB, the lowest level to qualify for that status, according to the O.E.C.D. That was up from 39 percent before the financial crisis.
That trend is troubling to financial experts because it leaves companies — and the world economy — especially vulnerable to a change in fortunes.
The world’s largest pools of money — asset managers that control pension funds, mutual fund operators, and insurance companies — are typically restricted in where they can invest. Many are obligated to hold the safest bonds.
When corporate bottom lines are threatened, credit ratings can be downgraded. Given that more than half of all investment-grade bonds now occupy the lowest rung of that classification, downgrades could render trillions of dollars’ worth of such holdings effectively radioactive. Money managers would be forced to unload them while buying safer assets. That would make credit tighter for many companies, threatening some with insolvency and constraining economic growth.
This was the situation before the coronavirus began its lethal, wealth-destroying wander around the globe. The widespread disruption to factories across Asia and in Europe, the effective quarantining of all of Italy, and the spread of the outbreak to the United States have threatened the earnings of thousands of companies.
Last month, Kraft Heinz, the maker of ketchup and other processed foods, had its debt slashed to junk status. Macy’s, the department store giant, as well as the carmakers Ford and Renault, have also suffered downgrades.
Fitch Ratings, the credit rating agency, last week said that one-fourth of the corporate bonds it tracks in Europe have been issued by companies impeded by government actions meant to limit the spread of the virus, like travel restrictions and bans on public gatherings.
Companies dependent on Italy appear especially vulnerable.
Poste Italiana oversees mail delivery while also selling financial, insurance and telecommunications services. The company’s debt is rated BBB. No great powers of imagination are required to grasp that the sequestration of the nation is going to stop customers from reaching post offices.
“We’re going to look at all cost-reduction measures,” the company’s chief executive, Matteo Del Fante, said in a recent presentation to analysts.
Before the outbreak arrived in Europe, CNH Industrial, which makes machinery for construction and agriculture, was cutting expectations for earnings, citing weak demand in North and South America. As of the end of 2019, it carried debt of nearly $25 billion. Its bonds are mostly rated BBB, and Italy is the source of one-tenth of it sales. Those facts seemed unlikely to bolster confidence.
History shows that perilous pressures can build for years inside major economies without disaster unfolding. Danger signs frequently turn out to be benign. Perhaps the wave of corporate borrowing will subside without a traumatic event to right the balance.
But if a nasty reassessment of risk lies ahead, bringing an economic crisis, the coronavirus outbreak could be the event that sets it in motion.
“This is exactly the type of thing that can trigger a chain reaction,” said Sonja Gibbs, managing director of Global Policy Initiatives at the Institute of International Finance. “The vulnerability in the corporate debt market has been building up for a very long time.”