The Hidden Debt Bubble You Didn’t See Coming
Submitted by Porter & Co.
After a staggering 12 years and 177 episodes, The Walking Dead was finally put out of its misery late last year.
And the same thing is about to happen to our current generation of “zombie” companies. High time indeed.
Now, it’s no secret that we’re gearing up for a massive crisis in high yield (aka “junk”) bonds...
As always happens when central banks flood the economy with cheap credit, the credit bonanza of the last decade fueled massive distortions in the economy. These distortions now must be resolved with a painful deleveraging event.
One of the biggest distortions came from keeping companies alive on life support that otherwise would have disappeared into insolvency. That’s how the cheap money charade of the last decade gave birth to a ghoulish horde of zombie companies – ones that don’t earn enough in pre-tax profits to pay the interest on their existing debt.
In any normal economic regime, these companies should not, and would not survive. But when the Fed dropped interest rates to a then-record low of 1% in 2002 in the wake of the Dot Com bust, they sponsored a proliferation of zombie companies, which more than tripled from 100 to 300 by 2008.
Then, the monetary and fiscal authorities prevented a true default cycle in 2008. The endless supply of cheap credit over the last decade enabled these zombie companies to continually refinance their maturing debts with new bond issuance, keeping them clinging on to the life support provided by central banks:
Now, finally, the Fed’s aggressive rate hiking campaign is pulling the plug on zombie corporations. The cost of capital for “junk” bonds has spiked — nearly doubling from 8% at the start of 2022 to 15% today:
Expect a surge in defaults among zombie companies in the coming years, as they’re forced to refinance their debt at prohibitively high interest rates.
But zombie companies are just the tip of the iceberg, making up a relatively small portion of the total corporate debt pool.
There’s actually a much bigger debt problem hidden in plain sight – under the respectable aegis of “investment grade” bonds…
The Biggest Bubble of All: “Investment Grade” Debt
Corporate debt ratings will play a critical role in shaping the coming collapse in the bond market, so let’s briefly review how it all works…
The top three credit ratings agencies, including Moody’s, Fitch and S&P Global, assign different grades to corporate bonds. These grades are based on key metrics like interest expense relative to profits.
The highest rated debt classification is triple-A, reserved for the most pristine balance sheets. The zombie companies described above fall on the opposite end of the spectrum, with grades of triple-C or below.
And in between these two extremes, there’s a critical demarcation line between “investment grade” and “non-investment grade” bonds. As shown below, the triple-B credits sit on the last rung of the ratings ladder that are still considered “investment grade”:
This bright line between “investment grade” and “non-investment grade” bonds will play a major role in the coming corporate debt implosion.
But first, it’s important to note that triple-B bonds were the single biggest beneficiary of the corporate credit bubble of the last decade. From 2007 through 2021, the value of triple-B bonds in the U.S. surged from roughly $700 billion to a record high of over $3 trillion today.
This explosion in issuance made triple-B debt the single biggest segment of the corporate bond market, which is now a record 58% of the investment grade universe:
Meanwhile, the quality of investment grade deteriorated as ratings agencies became more lax in providing their stamp of approval over the last decade. The chart below shows how the leverage ratios of the investment grade debt universe roughly doubled from 1.5 times in 2007 to 3.0 times today:
Once again, history rhymes. The ratings agencies played a major role in helping the mortgage bubble expand in the early 2000s, by rubber stamping low-quality mortgage bonds with triple-A credit scores.
This time around, the ratings agencies allowed corporate bond funds to package this increasingly risky debt into the retirement accounts of millions of Americans. If you have assets in a traditional 401(k) or IRA retirement plan, chances are you might own some of these bonds. (It’s worth a look into your account.)
Today, an even greater financial calamity — and even greater opportunity — looms on the horizon. It will make 2008 look like child’s play. And trillions of dollars in wealth will change hands…
On the other side of every panicked asset sale in 2008, there was a buyer. Capitalizing on that opportunity required only two things: you had to know what was coming, and you had to prepare ahead of time by raising cash. We have more on the greatest distressed debt opportunity of all time here.