PLAIN- VANILLA DEBT COULD BRING PAIN IN NEXT CRISIS / THE WALL STREET JOURNAL

Plain-Vanilla Debt Could Bring Pain in Next Crisis

Amid concerns about rising corporate debt, ordinary investment-grade bonds deserve more scrutiny

By Aaron Back


The Federal Reserve earlier this month highlighted corporate debt risks, including plain-vanilla bonds. Photo: chris wattie/Reuters


Federal Reserve Chairman Jerome Powell warned this week of dangers from rising business debt, saying it makes the U.S. economy more vulnerable. He follows many analysts and investors who have raised alarms over the growth in leveraged loans and the securities they are packaged into.

But these concerns shouldn’t overshadow potential risks in ordinary corporate bonds—even investment-grade ones.

Earlier this month, the Fed’s financial stability report highlighted corporate debt risks, including plain-vanilla bonds. The share of investment-grade bonds rated in the triple-B category—the rung just above speculative grade—has reached record levels, the Fed noted in the report.

According to Fitch Ratings, BBB-category bonds—which includes BBB+ and BBB- ratings—accounted for 59% of investment-grade bonds outstanding in 2018, up from just under half in 2011. That is equivalent to around $2.2 trillion of debt that could be vulnerable to downgrades in the next economic downturn.

The Fed sees potential domino effects if large amounts are lowered to speculative or so-called junk status. It notes that, among U.S. financial institutions, insurers are the biggest investors in corporate bonds and that they face higher capital requirements for holding speculative-grade debt. For life insurers, when a bond is downgraded to speculative grade, the after-tax capital charge for holding it more than triples, according to the National Association of Insurance Commissioners.

If insurers become forced sellers after these bonds are downgraded then they could flood the smaller, less-liquid market for speculative-grade debt, the Fed warned, causing further ripple effects.

Not everyone is so alarmed. In a December note, S&P Global estimated that perhaps $200 billion-$250 billion of debt could be downgraded to speculative grade in a recession as severe as the last one. That sounds like a lot, but the ratings firm notes it would be similar to past downturns as a percentage of the speculative-grade market.

Among bond issuers, especially high leverage ratios are concentrated in industries with less cyclical risk, S&P added, including utilities, real-estate investment trusts, and consumer staples.

But every downturn is different. For instance, even in boom times it is already apparent that consumer staples, including packaged food and household goods, aren’t as stable as they used to be. Shifting consumer tastes and disruption from e-commerce are putting pressure on sales and margins. This pressure could intensify in a recession as consumers become more price sensitive. Leverage in this sector has also been run up by aggressive merger activity.

Sometimes the biggest risks lie not in exotic places but seemingly mundane ones. Investment-grade bonds deserve more scrutiny.