Financial stability report presents bright outlook – but paints gloomy picture of risky business debt

Borrowing by businesses is historically high, with the most rapid increases in debt concentrated among the riskiest firms amid weak credit standards, the Federal Reserve reported in its latest “financial stability report” for 2019.

The report, which the Fed said summarizes its framework for assessing the resilience of the U.S. financial system and presents the central bank’s current assessment, also noted that not only is business debt at record highs, but that risky debt issuance has remained robust. “The net issuance of riskier forms of business debt – high-yield bonds and institutional leveraged loans – shows some variation in recent quarters but has remained robust, overall, in 2019,” the report states.

In addition, the report states, about half of investment-grade debt outstanding is currently rated in the lowest category of the investment-grade range (triple-B), which is near an all-time high, the report states.

The report notes that in an economic downturn, widespread downgrades of bonds to speculative-grade ratings “could lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity.”

The report also points out that credit standards for some business loans remain weak, and balance sheet leverage of businesses (the ratio of debt to assets for all publicly traded nonfinancial firms) is near its highest level over the past 20 years.

However, the report points out, low interest rates have contributed to keeping the ratio of corporate earnings to interest expenses high for the median firm and near the historical median for riskier firms, which are those in the bottom 25th percentile of the distribution of the ratio.

The report also notes:

  • Household borrowing remains at a modest level relative to income, and the amount of debt owed by borrowers with credit scores below prime has remained flat.
  • The largest U.S. banks remain strongly capitalized, and the leverage of broker-dealers is at historically low levels. “However, several large banks have announced plans to reduce their voluntary capital buffers,” the report observes.
  • Asset prices remain high in several markets relative to income streams – although “risk appetite measures that account for the low level of long-term yields on U.S. Treasury securities are more aligned with historical norms for most markets.” The report states that, with the exception of riskier corporate debt, commercial real estate (CRE), and farmland markets, “these measures point to a reduction in risk appetite from the elevated levels of 2017 and 2018.”
  • Estimates of the total amount of financial system liabilities that are most vulnerable to runs (including those issued by nonbanks) “remain modest.” Short-term wholesale funding continues to be low compared with other liabilities, and the ratio of high-quality liquid assets to total assets remains high at large banks.

Federal Reserve Financial Stability Report, November 2019

Be the first to comment

Leave a Reply

Your email address will not be published.