Fed Chair Jerome Powell, former Fed Chair Janet Yellen and former Chair of the FDIC Sheila Bair, have all highlighted a concern for corporate debt levels, notes Lindsey Bell. Bell will be speaking at the MoneyShow Orlando Feb.  7-10.

Current Federal Reserve Chairman Jerome Powell, former Fed Chair Janet Yellen and former Chairwoman of the FDIC Sheila Bair, have all recently highlighted a concern for corporate debt levels.  The reason for their concern is that when credit goes bad, recessions and sharp market downturns typically follow. Debt has a long history of rising ahead of, and sometimes causing, an economic crisis. The increase could come from households or corporations. Household debt was the driver of the last recession. Given the track record of credit ahead of crises, we decided to examine the current status of household and corporate debt to determine if there are signals for a potential downturn.

We too found some red flags with regards to corporate debt levels. However, the concerns aren’t as intuitive as you would think. As of Q3 2018, there was $9.6 trillion in outstanding corporate debt, 75% higher than the $5.5 trillion outstanding ten years ago. Corporate debt as a percent of GDP (a measure we aren’t big proponents of, but that is a conversation for another time) is at an all-time high, approaching 46% (the last peak was 45% in Q1 2009). The quality of this debt is of key concern as it is anticipated that the credit ratings system may be deteriorating.

Much of the investment-grade debt in the market is rated in the lowest rungs of the investment-grade credit scale. The percentage of BBB (lowest tier of investment grade or one notch above junk) corporate bonds by value now represents well over 40% of all corporate debt, much higher than ever before. Some investors have expressed concern that there might be subtle “grade inflation” by the credit rating agencies and that some of these lowest-tier investment grade bonds do not deserve to be investment grade. Indeed, ratings agency Moody’s described the amount of investment-grade debt outstanding as “riskier now that it was prior to each recession since 1981 and possibly all downturns through late 1940.”

Despite the quality concern, amid rising debt levels, defaults have remained at lows. Improvements in profitability, lower tax rates and a strong economic environment have likely been drivers of this trend. A swift change in that environment could put corporations at the center of a new crisis. That said, not all corporations are the same.

Find out where we believe the most risk lies. We analyze corporate debt levels, leverage and cash balances at both the large-cap and small-cap level. We also review households’ debt status in the following report:

Sector Intellect Trend Analysis – Debt Analysis

This week’s thoughts come with the help of PwC Partner & Business Development Leader, Mitch Roschelle.