Default Risk Debt-ja Vu All Over Again

A surge in corporate loans, especially in the United States, could unleash a new global financial crisis. That should worry Germany, too, writes the head of Handelsblatt’s finance pages.
The big question: when will the bull market turn to a bear market. Getty Images [M]

It's an enormous number: Companies worldwide took up $3.7 trillion (€3.37 trillion) in new debt in the capital markets last year. That is not just $1.5 trillion more than Germany's total government debt. It also exceeds the previous record for new corporate bonds. The last time a similarly high level was reached was in 2006 – just before the beginning of the last major financial crisis.

It is a loud warning signal. The contours of a giant bubble are becoming more and more apparent in the market for corporate bonds. It could burst in the coming years, due to rapidly rising interest rates and a declining economy. In parallel to the gigantic real-estate bubble of the previous decade, the United States could once again become the trigger and possibly the epicenter of the next crisis. And, once again, major German investors would be one of the many victims.

Some would call this a farfetched theory, but unfortunately it is supported by many facts and warnings from renowned professionals.

A look at the bond market provides some proof: According to the International Monetary Fund, companies in the United States alone have increased their debt within seven years by a breathtaking $7.8 trillion – more than two-fifths of US economic output. Companies have already increased their debt significantly in many emerging markets – often in dollars, which is far riskier due to the currency risk. And while the trend is less pronounced in Europe, it does still exist.

Only 3 percent of companies in the United States and Europe invest the money from investors in long-term projects.

The market is partly fueled by major investors such as insurance companies and pension funds, which traditionally invest mainly in government bonds. However, negative interest rates in large parts of Europe and Japan are driving these investors into riskier investments, such as corporate bonds. It is estimated that in some large insurance companies and pension funds, the latter account for up to 15% of the investment portfolio. German insurance giant Allianz, for example, has a portfolio of corporate bonds of more than €220 billion, of which half have a medium to poor credit score from rating agencies.

The problem is that enormous demand is driving up bond prices and pushing down yields. In Europe, investors are only able to earn about a percentage point more in yield for the bonds of sound companies than for more secure government bonds. The gap is also low because a new buyer has been active in Europe: The European Central Bank. As part of its huge bond-buying program, the ECB has bought up €82 billion in corporate bonds since last summer. This has fueled the market enormously, so much so that some companies, such as Sanofi or Henkel, have even issued bonds that give investors less money back than they invested.

Perhaps this wouldn't be such a bad thing if the companies were to invest all the money that is practically being thrown at them in their future. But unfortunately this is rarely the case. Again, the statistics – this time from the Institute for International Finance, a financial industry lobbying group – are quite shocking: Only 3 percent of companies in the United States and Europe invest the money from investors in things like machinery, buildings, IT systems and other long-term projects.

Companies are getting more and more into debt merely to drive up their share prices in the short term.

Then what are the companies doing with the money flooding in their direction, thanks to ultra-relaxed monetary policy? It's very simple: instead of providing for the future, they are spending it for short-term purposes: share buybacks, dividends and opportunistic takeovers of competitors. In other words, the companies are getting more and more into debt merely to drive up their share prices in the short term. This trend is especially pronounced in the United States. There, the debt bonanza has led to the fact that today one-tenth of these companies cannot pay their interest burden with current profits – and this at a low key interest rate of 0.75 to 1 percent.

There are many predetermined breaking points in this fragile debt structure. As soon as interest rates go up and the economy begins to falter, default rates, which have been low until now, are likely to skyrocket. Above all, the scenario of rapidly rising interest rates is quite realistic, for example if US President Donald Trump increases government debt to pay for an infrastructure program. This would drive inflation and interest rates up along with it.

What is particularly worrying is the fact that the number of foreign investors in corporate bonds has risen steadily over the past years in the United States – to 29 percent most recently. It is safe to assume that these foreign investors also include many German insurers and pension funds. This is why regulators should remain vigilant, so that history does not repeat itself.

The author is head of Handelsblatt' finance pages. You can reach him at: [email protected]