Cautious Cash Investors Eye Burgeoning Corporate Debt
Remember CDO’s, those collateralized debt obligations at the center of the massive mortgage meltdown in 2008? These days, you can expect to start hearing about CLO’s, collateralized loan obligations, that are at the tip of a rapidly growing iceberg of leveraged corporate debt.
The recent growth of CLO’s is only one of many warning signs starting to flash yellow, if not red, for cautious institutional cash investors. Once-burned, twice-wary treasury professionals are keeping a sharp eye out for potential new systemic risks that may be creeping into the decade-long economic expansion. And they are zeroing in on the recent rapid growth of corporate debt.
Our latest white paper, Corporate Leverage: Par for the Course or Harbinger of an Upcoming Crisis?, provides an eye-opening account of the burgeoning share of higher-risk, higher-yield corporate debt in the economy. In 2018, non-financial corporate debt levels rose to well over 70% of U.S. gross domestic product, surpassing the previous peak hit just before the 2008 crisis. And, most of that growth in leverage has been through issuance of lower-quality debt with BBB ratings.
Recent research suggests that rapid build-ups in leverage, combined with increased issuance of lower-quality debt, may serve as a reliable leading indicator of an impending economic downturn. If so, now is a good time for corporate cash managers to take a close look beneath the covers of leveraged debt offerings available for their portfolios.
Many of those investments might continue to provide the higher yield managers are looking for as they balance other investments that limit overall risk, especially with stronger financial regulation in a full-employment economy that continues to grow at a healthy pace. But in the meantime, our research report identifies three specific risks for which to watch out.
First, there are the “fallen angels”: in an economic slowdown, some issuers’ investment-grade BBB debt can quickly downgrade to junk status and lead to investor losses. Second, there’s potential for financial contagion if the overall value of leveraged debt held in the less-regulated “shadow-banking” sector turns south. And third, there is liquidity risk: highly leveraged corporates sensitive to economic and industry shocks may foster expectations of lower liquidity, resulting in a self-reinforcing cycle of negative sentiment and decreasing liquidity.
And finally, what about those CLO’s? By bundling and syndicating lower-rated debt into higher-rated investment-grade products, they have attracted plenty of investors who might normally be averse to products with potential hidden risks. Sound familiar? If not, just ask anyone who lived through 2008.