Central bankers are caught in a leverage trap

Central bankers are caught in a leverage trap

Central bankers have spent years warning of the perils of excess corporate debt. But their solution to this year’s coronavirus storm in financial markets has led to even more of it. 

It is the Catch-22 of post-2008 policymaking, and of now post-pandemic policymaking, too. To stave off a debt crisis, monetary policymakers create conditions that allow companies to borrow even more, increasing the potential severity of the next crisis. No central banker wants to encourage excessive borrowing but, equally, no central banker wants to stand by while companies default, increasing unemployment and throttling economic growth. 

“The chosen solution to a debt crisis is more debt,” said Hans Mikkelsen, a credit strategist at Bank of America. “There is no escaping it. You cannot cut it back unless you can create a tremendous amount of economic growth to offset it. There is nothing the central banks can do.”

The risk now is of a serious setback in the global recovery from the virus. If that happens, the additional cash borrowed by companies expecting earnings to pick back up soon may prove to be too little to see them safely through to the other side. And now, they have a whole lot more debt to grapple with. 

More US dollar corporate bonds have been issued so far this year than in the whole of 2019, according to data from Refinitiv. More debt will come due next year than ever before. And leverage is rising. Top-rated companies’ net debt to ebitda — a common measure of the weight of a business’s debts — reached more than 2.4 times at the end of the second quarter, the highest level on record in BofA data going back 19 years. The bank’s analysts predict it will peak at 3.2 times at the end of this year.

Even if the recovery lasts, the mounting debt burden of businesses curtails policymakers’ room to raise interest rates, for fear of dramatically increasing refinancing costs. “Central bankers will come back and complain about corporate leverage in a few years, but it will be mostly their own creation,” said Mr Mikkelsen. 

We have been here before. To prop up an ailing economy following the 2008 financial crash, the Fed dramatically lowered interest rates and embarked on quantitative easing — buying government debt and mortgage bonds — pushing investors to seek out comparatively higher returns in riskier assets such as corporate bonds. 

This made borrowing cheap for businesses. The total number of US corporate bonds outstanding doubled in the decade since the 2008 financial crisis to more than $12tn, according to Refinitiv data. 

As the Fed began to slowly raise interest rates after that crash, it also began warning about corporate indebtedness. Every six months in its financial stability report beginning in November 2018, the central bank noted rising business debt and its potential to exacerbate an economic downturn. In September of last year Fed governor Lael Brainard told a congressional subcommittee that “excesses in corporate debt markets could amplify adverse shocks and contribute to job losses”.

“Over-indebted businesses may face payment strains when earnings fall unexpectedly, and they may respond by pulling back on employment and investment,” she said, in a submission that seems prescient in light of the Covid-19 shock.

Such a slowdown in activity, she went on, “lowers investor demand for risky assets, thereby raising spreads and depressing valuations. As business losses accumulate, and delinquencies and defaults rise, banks are less willing or able to lend. This dynamic feeds on itself, potentially amplifying downside risks into more serious financial stresses or a downturn.”

In March, this seemed to be happening. Earnings fell precipitously, unemployment skyrocketed, lending activity slowed as bond prices plummeted, and companies began defaulting on their debt. 

Then the Fed announced that it would expand its quantitative easing programme and begin buying corporate bonds. The effect was instantaneous. Without even making a purchase, the signal of support from the central bank squashed yields, pumped up prices and opened the floodgates for the fastest and largest borrowing spree ever. 

Companies from airlines to cruise ships that were on the brink of collapse have been able to raise cash to keep going. The Fed’s intention was to restore functioning markets, not to save failing companies, but untangling the two is not easy.

“Policy interventions may help businesses withstand a period of weak earnings by issuing new debt and extending existing credit,” notes the Fed’s latest financial stability report, released in May. But many of these businesses will emerge with even higher leverage, it added, “suggesting that vulnerabilities stemming from the business sector . . . are likely to remain elevated for some time”.

Without growth and inflation to offset the rise in indebtedness, the central bank has little choice, analysts say, other than to keep the show on the road by making sure businesses can refinance their new debts. “If they can’t do that, it’ll be massive defaults and a depression,” said Mr Mikkelsen.