Credit rating agencies are crucially important gatekeepers to the debt markets and the overall economy. Indeed, the Financial Crisis spun out of control because these agencies failed to do their job. The explosive growth of toxic debt instruments caught them flat-footed in the run-up to the crisis.
Specifically, rating agencies, like Moody’s and Fitch, rated collateralized debt obligations (CDOs) as investment grade. These CDOs were for the most part junk. And it was only a matter of time before they blew apart and nearly took down the world economy.
Fast forward a decade and we’re barreling towards the same disaster. This time around the problem is in corporate debt issuances. The average net debt to EBITDA for BBB-rated companies has surged from 2.1-times in 2007 to a lofty 3.2-times today. Some 37% of companies have a debt to EBITDA ratio higher than five.
That means these companies are on average 52% more indebted per unit of earnings today than they were up to the run-up to the Financial Crisis. Or to put it another way, much of the debt issued as low investment grade is effectively junk.
How the Rating Agencies Brought Us to the Edge of a New Financial Crisis
Credit rating agencies initially started to lower their hurdles for investment grade ratings because of near-zero interest rates. The assumption was borrowers could support higher debt loads because they had to pay negligible interest.
However, the Federal Reserve has been raising rates steadily and that is pushing up borrowing costs for everyone. Accordingly, the yield on BBB-rated bonds has risen by 0.79% on a year-on-year basis to 4.27%. And with Fed signaling two more rate hikes this year, these yields (and the cost of borrowing) will continue to climb higher.
That’s going to be bad news for corporates that have to issue new debt or roll over their existing debt. Their interest expense will rise, further degrading their already tenuous credit quality.
Moreover, BBB-rated corporate debt issuances have surged from $700 in 2008 to an eye-watering $3 trillion now. These wannabe investment grade issuances now constitute about half of all investment-grade debt. That’s a new record and much higher than in 2008.
This is a ticking time bomb at the heart of the global financial system. The trigger that will set it off could come in a myriad of ways.
Rising interest rates could push the cost of carrying this debt to an unbearable level. Or the next recession could force a wave of defaults. Or some unknown crisis could shake up financial markets and knock this domino down as well.
However, it’s only a matter of time before a financial reckoning. When that happens, these issuances could fall steeply as some institutional investors aren’t allowed to hold junk bonds. That means they will become forced sellers that will intensify the downdraft.
US corporate bonds and exchange-traded funds like iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and Vanguard Short-Term Corporate Bond ETF (VCSH) will bear the brunt of investor fury at the credit rating agencies.