Could the coronavirus trigger a business debt crisis? - Capital Economics
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Could the coronavirus trigger a business debt crisis?

Global Economics Focus
Written by Simon MacAdam
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Our current assumption is that the virus-related disruption is not severe enough to prompt a widespread business debt crisis. But if the virus triggers a sharper drop in profits or a bigger rise in borrowing costs than we envisage, then these pockets of vulnerability could blow up. Although the global banking system appears to be better placed to deal with such turbulence now than at the time of the global financial crisis, at the very least this could exacerbate any virus-related global downturn.

  • Our current assumption is that the virus-related disruption is not severe enough to prompt a widespread business debt crisis. But if the virus triggers a sharper drop in profits or a bigger rise in borrowing costs than we envisage, then these pockets of vulnerability could blow up. Although the global banking system appears to be better placed to deal with such turbulence now than at the time of the global financial crisis, at the very least this could exacerbate any virus-related global downturn.
  • A decade of loose monetary policy has created an enduring environment of low returns on financial assets. The risk is that the resulting hunt for yield has caused bubbles to inflate, sowing the seeds of the next major downturn. And concerns have centred on the rise in indebtedness in the non-financial business sector. The global debt-to-GDP ratio in this sector is near a record high of 94% and is at, or near, all-time highs in many major economies.
  • This is not as alarming as it first appears, given that there are reasons for debt ratios to be higher than in the past. Lower interest rates, financial innovations, tax policy, financial deregulation and globalisation have all raised “equilibrium” debt ratios. As for concerns that the real problem is a big rise in the debt ratio – rather than a high level – non-financial business debt ratios are presently in line or below their trend paths in most major economies. Indeed, at the aggregate level, firms generally look well-placed to service their debt.
  • There are some exceptions, though. China and Turkey stand out as cases where corporate balance sheets are bloated and banks are heavily exposed to them.
  • What’s more, the aggregate picture can only tell us so much. It only takes a portion of business debt to become unserviceable for there to be wider economic and financial consequences. Digging a bit deeper suggests that there are four pockets of business debt where the risks are high.
  • First, the debt service capacity of the energy extraction industry – whose earnings are sensitive to the prices of energy commodities – is weak by past standards in most major economies.
  • Second, a “BBB bulge” in the US and euro-zone corporate bond markets raises the prospect of widespread credit rating downgrades to junk status, which would impose hefty costs on borrowers and investors alike.
  • Third, leveraged loans in the US and Europe have grown a lot while credit quality has fallen. And, given the growth of collateralised loan obligations, the financial sector is now more exposed to leveraged lending.
  • And fourth, even in cases where business accounts seem to be in good shape, increasing use of questionable accounting practices could be disguising the true extent of the increase in leverage over the past decade.
  • So, even though the overall non-financial business sector is not about to buckle under the weight of its debt, there are clearly parts that look vulnerable to a big drop in corporate profits or surge in borrowing costs. The greater the virus-related disruption, the closer we will get to this tipping-point.

Could the coronavirus trigger a business debt crisis?

Concerns about indebtedness in the non-financial business sector[1] have been building for a while. Now there are fears that the coronavirus-related disruption could be the trigger for the risks in the sector to crystallise.

In this Focus, we start by considering the general case for optimism. But we’ll then point out three reasons to nonetheless be concerned. First, a high level of indebtedness makes an economy more vulnerable to negative shocks. Second, surveying the current state of business balance sheets in medium- and large-sized economies throws up some concerning cases at the country level. And third, once we peer beneath the aggregate of the non-financial business sector, it turns out that there are various pockets of risks related to specific industries, deteriorating credit quality and associated financial stability risks, as well as firms’ systematic under-reporting of leverage.

Some reasons not to worry

In its latest Global Financial Stability Report, the IMF claimed that balance sheet vulnerabilities in the business sector are “elevated” in numerous major economies. At the global level, non-financial business debt is at an all-time high of 94% of GDP. Most of the rise in the global debt ratio since 2010 has taken place in China, which we will come back to later. But even excluding China, it is close to a record high. (See Chart 1.)

Chart 1: Non-Fin. Business Gross Debt as % of GDP*

Sources: Refinitiv, BIS, Capital Economics

However, you could argue that the risks posed by high levels of business debt are overblown. For one thing, there haven’t been many business debt crises historically. You’d probably have to stretch back to the 19th century to find a recession that was widely attributed to a build-up of business debt. One example is the Reconstruction Era railroad boom in the US. Over-optimism about future returns led to a credit-fuelled surge in rail construction. From 1878 to 1880, railroad construction quintupled, rail stock prices doubled and high returns from operating railways sustained the growth in debt. (See Chart 2.)

Chart 2: US Reconstruction Era Railroad Boom

Sources: NBER, Babson Statistical Organisation, Railroad Gazette, CE

But so big was the accumulation of debt, railroads went bankrupt when revenues disappointed. The resulting decline in railroad construction had knock-on effects on output in related industries up the supply chain, particularly in iron and steel. Railroad company bankruptcies and deleveraging precipitated the Depression of 1882-1885 and railroad construction fell from a peak of 13,000 miles a year to below 3,000.[2] In the past 100 years, though, there have been no economic downturns that have been widely attributed to firms’ over-indebtedness.

The lack of historical precedent for business debt causing crises in modern times could reflect the fact that firms have an extensive capacity to cope with higher borrowing costs. They can cut overheads and liquidate accessible financial assets to cover current liabilities. And, compared to households, they tend to have more advanced treasury functions to manage credit and income flow risks, as well as a greater ability to renegotiate and restructure their debts. If it comes to it, rescue M&A deals can tide companies over so they can keep up with debt repayments.

All of this translates into fairly low default rates for businesses. Charge-off rates (uncollectable debt as a percentage of outstanding credit) on bank loans in the US have been consistently lower for firms than households during the past 25 years. (See Chart 3.)

Chart 3: US Bank Loan Charge-Off Rates (%)

Sources: Refinitiv, Federal Reserve

What’s more, there are structural reasons why debt ratios should be higher today than in the past. For a start, interest rates are lower than they were in decades gone by. (See Chart 4.) With equilibrium interest rates historically low, higher debt levels can be sustained for a given level of income.

Chart 4: NFB* Interest Payments as % of Gross Debt

Sources: Refinitiv, OECD, ABS, ONS, CE. *Non-financial business

Moreover, liberalisation of domestic financial sectors in addition to financial globalisation have led to a greater competitive supply of credit for a given level of demand for debt. Debt ratios were low in the past because of barriers getting in the way of creditors matching up with would-be borrowers.

Also, there has been a shift in preferences regarding issuing debt rather than equity. Financial innovations such as securitisation, credit guarantees and insurance have made taking on debt safer for individual debtors, which in turn has reduced the relative appeal of issuing equity. Interest tax deductibility reforms have also made accumulating debt more attractive.

In addition to the apparent rarity of business debt-induced crises and the accommodating structural changes that have taken place in recent decades, a third reason not to worry about the present state of firms’ balance sheets is that there is currently little evidence of destabilising credit booms.

Some argue that it is changes in debt ratios or, more specifically, deviations from their trend that really matter in terms of risks to the economy, not their level. This is because a rapid build-up in debt relative to economic output can signal capital misallocation: surging credit-to-GDP ratios may suggest that, having picked the low-hanging fruit, lenders are drawn to investing into less productive projects. Another fear is that above-trend debt ratios go hand-in-hand with asset price bubbles.

However, in practice, there are no stand-out cases of large so-called “positive credit gaps” today. Business credit-to-GDP ratios are presently below their trends in most major economies; i.e. credit gaps are negative. (See Chart 5.) Where they are above trend, they are less than 1½ standard deviations away, which isn’t enough to be deemed solid evidence of unsustainable booms in business credit.

Chart 5: NFB “Credit Gaps” (Deviations of Gross Credit-to-GDP Ratios from Trend, Std. Deviations)

Sources: Refinitiv, BIS, Capital Economics

High debt is an automatic destabiliser

But while there is something to these arguments, there are more convincing reasons why we should be concerned by the current state of business debt.

The first reason is that high debt prompts firms to deleverage when profits fall, imposing costs on the wider economy. Indeed, while low-debt business sectors typically shrug off falling profits, high-debt ones undergo a period of deleveraging to bring their financial balance back to surplus. (See Chart 6.)

Chart 6: NFB Financial Balance in OECD Economies Around Downturns* (% of NFB GVA, T = Downturn)

Sources: Refinitiv, Eurostat, OECD, ABS, StatCan, Capital Economics.
*Business downturn defined as two consecutive quarters of falling disposable income. Sample: 84 downturns in 18 countries (1986-2016).

In addition to cutting back on capital expenditure, deleveraging can involve laying off workers and freezing their pay. This then hits demand, which in turn prolongs downturns which weighs on profitability, making further deleveraging more likely. While a high level of indebtedness does not itself precipitate recessions, by amplifying the effect of a negative shock on the wider economy, it can be thought of as an “automatic destabiliser”.

So, even though there are reasons why higher debt ratios can be sustained today compared to previous decades, high debt ratios still matter. And while it may look like there haven’t been many business credit-induced downturns throughout modern economic history, this is because deleveraging firms generally push much of the pain onto households.

Country-level data reveal some concerns

A survey of the current state of aggregate business sector finances reveals a couple of areas of concern. The dashed line in Chart 7 marks the current level of the global debt-to-GDP ratio, while the columns compare individual economies’ current debt ratios with their levels a decade ago.

Chart 7: Non-Fin. Business Gross Debt as % of GDP

Sources: Refinitiv, BIS, Capital Economics

Business debt as a share of GDP is highest in Hong Kong, having grown by 100% of GDP since 2009. Business debt burdens are also much higher than average in Canada, the Nordics, France and China.

However, gross debt-to-GDP ratios are far from ideal metrics of balance sheet health. Firstly, they do not take account of businesses’ holdings of liquid assets, which can be used to pay down debt. And secondly, we are more interested in comparing debt to the income that is actually available to businesses to meet their financial obligations, rather than GDP.

Box 1 looks at this is more detail. The upshot is that, in most developed economies, the aggregate picture is not too concerning. The exception is Canada. After a flattening off in the aftermath of the financial crisis, total net debt of Canada’s non-financial business sector began shooting up in 2011. A third of the rise since then has been due to inter-company claims, leaving two thirds explained by higher borrowing from outside the NFB sector. The real estate sector accounts for over a quarter of the rise in consolidated net debt, and the transportation and storage industry almost a fifth. (See Chart 8.)

Chart 8: Cumulative Change in Canada NFB Consolidated Net Debt Since 2011 by Sector (CA$ bn)

Sources: StatCan, Capital Economics

The primary concern lies within the oil, gas and mining industries. Admittedly, only 12% of the rise in consolidated net debt during the past 9 years has been in the extraction sectors, and their outstanding net debt makes up just 14% of the total owed by non-financial businesses. But high borrowing costs and poor earnings – particularly in the oil and gas industries – mean that operating profits barely cover interest expenses. In contrast, interest cover ratios are higher in other sectors of the economy and are high by past standards.

Box 1: Comparing business indebtedness in DMs

Looking at net debt-to-income ratios is not enough to get a clear idea of where there are balance sheet vulnerabilities. The problem is that when earnings are unusually strong, current debt ratios improve the appearance of firms’ financial health. In weaker phases of the earnings cycle, firms may become unable to service the same level of debt.

Consequently, there is a strong case for comparing net debt to available business income that is adjusted for swings in the earnings cycle. In a similar vein to Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE) – which attempts to gauge the underlying valuation of equities – we have estimated cyclically-adjusted debt-to-earnings ratios (CADEs) for advanced economies. The analysis is limited to DMs due to a lack of data for emerging economies.

Chart 9 shows the case of France as an example. Available business income is adjusted for cyclical volatility using a ten-year moving average. By using a smoother series for business income, the CADE gives a better sense of the underlying state of indebtedness than the current net debt ratio.

French business sector earnings have grown quite strongly in recent years. So aside from a one-off spike in 2018, the current debt ratio has been fairly stable at around nine since 2016. But because net debt has grown faster than cyclically-adjusted earnings, the French CADE – the blue line – has continued to rise to new record highs.

Chart 9: France NFB Net Debt-to-Available Income

Sources: Refinitiv, OECD, Capital Economics

Chart 10 shows that while CADE ratios are lower than, or close to, their average levels since 1999 in most advanced economies, they are high in Canada and France, as highlighted in grey. Admittedly, debt ratios are high in the Netherlands, Belgium and Sweden from a cross-country perspective (see light blue bars). But, like in most other countries, they are lower than or close to average levels, which suggests that firms there have not overextended themselves.

Chart 10: NFB Cyclically-Adjusted Debt-to-Earnings Ratios (CADEs) in Advanced Economies

Sources: Refinitiv, OECD, StatCan, Capital Economics

In France’s case, we don’t think that high business indebtedness warrants serious concern. This is largely because the growth in France’s business debt burden wholly reflects intra-company debt, rather than debt issued to external creditors. France has an abnormally large quantity of debt issued between affiliates of associated corporations: they amounted to over 63% of GDP in 2018, compared to 9% in Germany and 2.5% in Italy. Since it is effectively an internal source of finance, related defaults are likely to have limited economic and financial implications. On a consolidated basis (stripping out intra-company claims), the French CADE ratio was in line with its decade average in 2018 and lower than in some other European countries. (See Chart 11.)

Chart 11: NFB Cyclically-Adjusted Consolidated Debt-to-Earnings Ratios (CADEs) in Advanced Economies*

Sources: Refinitiv, OECD, StatCan, CE.

*Data not available for the US, euro-zone & Australia.

However, high business indebtedness in Canada is more worrying. While its consolidated CADE ratio is mid-ranking by international comparison, it is high by past standards within Canada itself, which may mean that it is reaching unsustainable levels.

This is shown in Chart 12 by the crosses being high up in historical ranges.

Chart 12: Canada NFB Interest Expense Cover Ratios
(Operating Profit/Interest Expense, 1999-2019)

Sources: StatCan, Capital Economics

While its debt ratio is mid-ranking compared to DM peers, Canada’s interest-to-cyclically-adjusted income ratio is by far the highest. (See Chart 13.) Low earnings coverage of interest expenses leaves firms susceptible to falls in income, and the profits of companies in the extraction industries are especially vulnerable because they are sensitive to commodity prices. (More on this later.) Given that these sectors make up almost a tenth of Canadian GDP, their precarious financial position poses a downside risk to growth. (See our Canada Economics Focus.)

Chart 13: NFB Net Interest Payments as a % of Cyclically-Adjusted Available Income

Sources: Refinitiv, OECD, ABS, StatCan, Capital Economics

Turning to emerging markets, due to a lack of national accounts data covering the whole non-financial business sector in individual emerging economies, we must rely on financial accounts of publicly listed companies in order to incorporate EMs into the analysis of debt service capacity. These data show that EM corporates are, in aggregate, less indebted than their DM counterparts but their interest expenses make up a larger share of earnings. (See Chart 14.)

Chart 14: Current Net Debt & Interest Expense Ratios*

Sources: Refinitiv, Capital Economics

*Based on actual, not cyclically adjusted, EBITDA of non-fin. PLCs.

At a country level, interest expenses make up a big chunk of cyclically-adjusted earnings in some large emerging economies, but the ratio is only historically high in Turkey. (See Chart 15.)

Chart 15: Interest Expense % of Cyc.-Adjusted EBITDA

Sources: Refinitiv, Capital Economics. Data for non-financial PLCs.

We have long warned about the mounting balance sheet vulnerabilities in Turkey’s non-financial business and, ultimately, banking sector. Turkey’s banks came through the currency crisis in 2018 relatively unscathed. But since then, increased state intervention in lending decisions, greater FX exposures, and poor asset quality in the form of outstanding loans to the still-bloated domestic business sector mean that the next time Turkey faces a crisis, the fallout in the banking sector and the wider economy will probably be severe. (See our Emerging Europe Focus.)

In China, interest expenses relative to smoothed earnings of companies listed on the Shanghai, Shenzhen and Hong Kong stock exchanges are lower than their average level during the past decade. But these data from public corporations offer only limited insight into the vulnerabilities of the country’s wider non-financial business sector.

Indeed, at close to 160% of GDP, the Chinese business debt ratio is the second highest among the world’s medium and large-sized economies. As we mentioned earlier, most of the increase in the global debt-to-GDP ratio since 2010 has been due to China. Given the size and importance of China’s business sector to the world economy, its vast accumulation of debt is potentially most concerning.

Admittedly, China’s economy shares few of the vulnerabilities that made the fall-out from previous EM debt crises painful. For instance, foreign currency exposures are low in China, and so is the public sector debt ratio. What’s more, through its extensive control of the domestic banking sector and wider financial system, we think that China’s authorities can prevent widespread defaults on business debt and alleviate potential liquidity shortages to avert a systemic crisis. (See our China Economics Focus.) Indeed, this capability was partly demonstrated early last year when policymakers succeeded in containing the fallout from the insolvency of three regional banks.

Nonetheless, near-term risks to the growth outlook in China have risen. Firstly, the coronavirus threatens to cause prolonged economic disruption. It is true that policymakers in China appear to be on the cusp off unleashing a significant stimulus package. If all goes to plan, this should restore output and employment in the later half of 2020. (See here.) But looser policy could turn out to be ineffective, or there could be a renewed containment effort in response to a new wave of inflections. Either way, it is possible that there will be a big enough and sustained slowdown in the economy to undermine firms’ capacity to service debt.

Chart 16: China Non-Fin. PLC Net Debt-to-EBITDA*

Sources: Refinitiv, Capital Economics. *Based on A, B & H shares.

Secondly, even if the economic fallout from the coronavirus proves temporary, high indebtedness in China’s real estate sector remains a concern. Much of the increase in non-financial leverage in the years following the global financial crisis occurred in the real estate sector, principally by property developers. (See Chart 16.) But property sales have been subdued for over a year now, inventories of unsold homes are rising, property controls and lending standards remain tight, and urban housing demand has entered a structural decline. (See our China Property Handbook.) Consequently, the strong pace of construction that has propped up overall growth in recent quarters will soon prove unsustainable, and debt will become more difficult to service.

To sum up this section, while aggregate business sector finances don’t look alarming in most major economies, there are a few concerning cases. Canada is where the main risk lies among advanced economies, while China and Turkey are the main exceptions to the general picture of reasonably robust business finances in major EMs. Of these, China obviously poses the greatest threat to the global economy, given its size. But one caveat here is that a lack of good quality data for emerging economies means that it is difficult to get a strong sense of the vulnerabilities there.

So far, we have inspected non-financial business sectors as a whole. But a key lesson from history is that some of the biggest threats are undetectable at the aggregate level until it’s too late. It turns out that when we dig beneath the surface there are indeed some concerning pockets of risk.

Weak debt service capacity in the energy sector

The first pocket of risk is in the oil and gas sector. Even if business sectors in two economies appeared to have comparable financial health at the aggregate level, balance sheet risks would be more worrying where debt was more concentrated in cyclical sectors of the economy, such as materials and industrials. This is because their earnings – and therefore their capacity to service debt – swing around more with the business cycle, whereas income streams are fairly stable in so-called “defensive” sectors like utilities and healthcare. (See Chart 17, which shows how earnings of cyclical and defensive industries vary around their trend.)

Chart 17: EBITDA of Global Non-Financial PLCs
(% deviation from trend, 2-quarter moving average)

Sources: Refinitiv, Capital Economics

Chart 18 shows the variability of earnings by industry. While the energy extraction sector is sometimes classified by investors as defensive, its earnings are especially volatile due to swings in energy prices. Similarly, the earnings of companies in the materials sector are sensitive to movements in the prices of commodities more generally. Therefore, weak or deteriorating debt servicing capacity in commodity industries would be the most concerning.

Chart 18: Variation in EBITDA of Global Non-Fin. PLCs (Std. deviations of % gaps from trend, 2005-)

Sources: Refinitiv, Capital Economics

According to income statements of global corporates, interest cover ratios fell in the year to Q3 2019 but remain close to normal levels. (See Chart 19.)

Chart 19: Interest Cover Ratios of Global NFPLCs
by Industry (EBIT/Interest Expense)

Sources: Refinitiv, Capital Economics

While earnings coverage of interest expenses has improved in the energy sector, like with healthcare, it remains low by past standards.

We are not concerned by the build-up of debt in healthcare companies because of their relatively strong position to ride out the economic storms with their steady flow of earnings. But oil and gas companies are clearly vulnerable to a fall in energy prices, and – given their current low interest cover ratio – more so than in the past. While our central forecast is for oil prices to rise this year, there is clearly a considerable risk that prolonged virus-related economic disruption in the world economy weighs on energy consumption and therefore prices.

On past form, when oil prices fall below $50pb for sustained periods of time, the world’s energy companies struggle to generate enough earnings to cover interest expenses. (See Chart 20.) Coronavirus fears have already pushed Brent down to $50pb. If containment measures end up having a more detrimental effect on global energy demand than is currently anticipated, prices could conceivably fall and stay below the $50pb threshold.

Chart 20: Brent Oil Price vs. Interest Cover Ratio of Global Energy Extraction Sector PLCs (2010-2019)

Sources: Refinitiv, Capital Economics

Chart 21 is a heat map of sector-by-country interest cover ratios to identify where sector-specific balance sheet risks are greatest. The colour coding is based on the current level of the ratio in relation to both past (within each country) and international standards. The selected countries are those for which there are numerous listed corporations in most industries.

Chart 21: Heat Map of Interest Cover Ratios of Non-Financial PLCs by Sector (EBIT/Interest Expense)*

Sources: Refinitiv, Capital Economics. “n/a” = too few companies for any meaningful insight.

*Colour coding: Red– low by past and international (int’l) standards; Orange– low by past and medium by int’l standards, or medium by past and low by int’l standards, or low-medium by past and int’l standards; Yellow– medium by past and int’l standards; Green– high by past and medium by int’l standards, or medium by past and high by int’l standards, or high by past and int’l standards.

Consistent with the international industry data in Chart 19, the heat map shows that earnings coverage of interest expenses is low in the energy and healthcare sectors in multiple major economies. It also shows that debt service capacity is stretched in the utilities sector in several cases. But since, like healthcare, utility companies are typically resilient to swings in the business cycle swings, the energy sector is the only real concern at the industry level.

“BBB bulge” in the corporate bond market

The second concern relates to worsening credit quality of corporate bonds in advanced economies. This is illustrated most clearly by the trend increase in the share of outstanding bonds rated BBB. In 2011, BBB-rated corporate bonds made up about a third of the market. Today, they account for almost half. (See Chart 22.)

Chart 22: Face Value of Outstanding Corporate Bonds
(Sum of US & Euro-zone, $ Trillions)

Sources: ICE BoAML, Bloomberg

In the US, the value of BBB-rated corporate bonds equates to 14.5% of GDP, versus 10% a decade ago. The euro-zone corporate bond market is much smaller, but the share has doubled from 3% to 6%.

And within the BBB segment, the share of bonds rated BBB minus – the lowest investment-grade rating – has risen too, largely through a mixture of rating downgrades and lower-rated new issues. That said, the share of bonds rated BBB plus – the highest quality of the BBB segment – has also risen.

But a widely held concern is that the “BBB bulge” raises the prospect of large-scale credit rating downgrades to junk status should a negative shock to incomes come along. This repricing of risk would raise borrowing costs for downgraded firms and increase rollover risk for existing sub-investment grade issuers. Meanwhile, investors would take a hit from credit losses. And fire sales by rating-sensitive fixed income portfolio managers (who face limits on the value of sub-investment-grade securities they can hold) could cause market liquidity to dry up. With low-rated borrowers effectively cut off from a key supply of credit, defaults and deep deleveraging would be much more likely.

And yet tight corporate credit spreads in the US and the euro-zone suggest that bond investors judge credit risk to be low despite an apparent deterioration in credit quality. (See Chart 23.)

Chart 23: Option-Adjusted Spreads of
Investment-Grade Non-Financial Corporate
Bonds over Sovereign Benchmarks (bp)*

Sources: ICE BoAML, Bloomberg. *Calendar-monthly averages

This is presumably because of investors’ optimism about future earnings and, by extension, firms’ ability to service their debts. Indeed, assuming that bond investors are on the same page as equity analysts regarding the outlook for corporate earnings, then low credit spreads arguably make sense – interest expenses as a share of earnings should not rise much above current levels if analysts’ expectations of future earnings come to pass. (See Chart 24.)

Chart 24: Interest Expenses as a % of EBITDA of
Non-Finanical PLCs in Advanced Economies
Under Various Earnings Scenarios[3]

Sources: Refinitiv, Capital Economics

However, an unanticipated shock to corporate earnings would strain debt service capacity and prompt a re-pricing of credit risk. A repeat of past earnings recessions today would lead to higher debt servicing costs than in previous downturn episodes owing to the starting point of higher debt burdens. For example, a repeat of the 2014-16 corporate downturn would see aggregate interest costs of non-financial PLCs surge to their highest level since 2010.

The rise of leveraged lending

Signs of deteriorating credit quality are palpable in the syndicated loan market too. Economic policymakers from around the globe fired verbal warning shots at the leveraged loan market back in 2018. They raised concerns about falling lending standards to highly-indebted firms, and the risks they posed to financial stability in advanced economies.

While protestations by policymakers – aided by the conclusion of the Fed’s tightening cycle – succeeded in tempering investor interest in the leveraged loan market, the vulnerabilities accumulated over the past decade have not gone away. These loans to sub-investment-grade companies – typically issued on borrow-friendly terms – now make up a sixth of non-financial business debt in advanced economies.

We give some more background on leveraged loans in Box 2. And in a Global Economics Update last year, we considered whether the growth of collateralised loan obligations (CLOs) – the special-purpose vehicles that hoover up leveraged loans, package them up and sell them on to institutional investors – has set the stage for a financial crisis. We concluded that the risk of a leveraged finance-induced financial crisis is quite low in the near term.

However, our optimism is not predicated on faith in the resilience of the financial system to leveraged loans and CLOs. Rather, it is based on our cautious optimism about the direction of the world economy. Clearly, the outbreak of COVID-19 has made the economic outlook a lot less certain. But, for now, we are assuming that the economic fallout in advanced economies will generally be limited and largely confined to the first half of the year. (See here.) If we’re right, the global recovery – which was seemingly about to commence at the outset of year – will soon be back on track.

In fact, we believe that leveraged loans and CLOs have stored up problems further along the line. Unless leveraged lending is reined in, when a large enough shock to corporate incomes comes along (and one will eventually!) a corporate subprime financial crisis will be almost inevitable.

Box 2: Q&A on leveraged loans

What are leveraged loans? While there is no universally accepted definition of a leveraged loan, typically they are syndicated, variable-rate loans to non-investment-grade companies. Approximately a quarter of them globally are revolving credit facilities (business overdrafts) and the rest are term loans. They are used primarily for M&A and refinancing purposes in advanced economies (principally in the US).

How big is the market? After rapid growth in recent years, the Bank of England estimated that the global stock of leveraged loans was around $3.2trn as of July 2019. For comparison, the current market value of outstanding bonds issued by non-investment-grade non-financial corporates in advanced economies is around $1.5trn.

Who holds leveraged loans? Credit facilities are almost entirely held by banks. Roughly 40% of term loans are held by banks and 60% by non-bank investors such as insurers, hedge funds and mutual funds. These term loans are owned either directly or via securities issued and managed by collateralised loan obligations (CLOs) – non-bank entities that apportion interest payments from the loans among tranches of securities with different credit ratings. (See Chart 25.)

Chart 25: Global Holdings of Leveraged Loans ($ trn)

Sources: Bank of England, Capital Economics

Are there big credit risks? The primary concern is a relaxation of lending standards. The share of new loans globally that are “covenant-lite”– loans that lack requirements for borrowers to meet regular financial tests, such as maximum leverage and minimum interest cover ratios – has risen to about two thirds, up from 5% a decade ago. In Europe, almost all newly originated loans lack maintenance covenants, and in the US, over 80% of outstanding loans are “cov-lite”. This means that capital is finding

its way into the hands of less credit-worthy “leveraged” borrowers. Indeed, the global average debt-to-EBITDA ratio of firms with leveraged loan liabilities has risen to a record high of more than 5x.

And the growing use of overoptimistic earnings projections and EBITDA add-backs – as discussed in the next section – mean that there could well have been a greater deterioration in credit quality in the leveraged loan market than it first appears. Indeed, in the US, the share of leveraged loan deals with add-backs has risen from 10% in 2009 to 40% today.

Are there risks to the banking sector? Parallels have been drawn with the run-up to the subprime crisis. Then, as now, there was a period of sustained credit growth to highly indebted borrowers, accompanied by falling lending standards and the packaging up of loans into complex financial instruments. What’s more, banking sector links to leveraged loans are sizeable. In addition to their almost $2trn holdings, banks have indirect exposures to the market by financing loan purchases by non-banks, such as by extending credit to private equity funds. The Bank of England estimate that direct and indirect exposures of a sample of global systemically important banks equates to about 75% of their core capital buffers.

There are a few caveats to bear in mind regarding banking sector links, which offer some measure of comfort. First, half of banks’ holding exposure is in the form of revolving credit facilities. These have stronger covenants, are ranked highest in repayment priority among debtor liabilities, and offer more flexible repayment than term loans. Second, banks’ holdings of term loans are mainly amortising loans – where debtors pay down principal in instalments – compared to the riskier market standard of loans with interest-only payment schedules and an eventual lump-sum repayment of principal. Third, banks’ CLO holdings are typically the prime cuts; non-banks such as hedge funds hold the riskier, junior tranches.

But none of this eliminates the risk of a banking crisis. While it’s true that banks typically only hold senior CLO tranches, if junior tranches were to end up running into trouble, it’d be because of a more general problem with leveraged loans. This is still a problem for banks because of their direct balance sheet exposure to leveraged term loans.

Systematic underreporting of leverage

Even in cases where corporate accounts look in good shape, this could be due to favourable accounting practices that are disguising the true extent of the increase in business indebtedness.

In recent years, corporate borrowers have been making increasing use of accounting techniques that can make earnings appear stronger than is often justified. These practices can help give the appearance of creditworthiness in the eyes of lenders, and therefore raise the chances of borrowers receiving credit on overly favourable terms.

One such practice is the use of projected earnings in income coverage ratios rather than current or trailing earnings. While it is true that a firm’s capacity to service its debt liabilities in the coming years will depend mainly on its future earnings performance, firms’ realised earnings have a habit of undershooting prior expectations.

EBITDA “add-backs” are another accounting practice that has gained popularity over the years. Add-backs are the re-addition of extra-ordinary or non-recurring expenses, as well as any synergies and cost-savings that are anticipated as a result of an M&A deal, back into estimates of earnings. This has been shown to substantially over-estimate earnings growth. Indeed, an investigation by S&P Global Ratings found that, for a sample of companies that used add-backs to adjust EBITDA which closed deals in 2016, the average undershoot of the firms’ earnings from their projections in the following year was around 35%, while none exceeded forecasts.

Such practices can lead to a considerable understatement of business leverage. For example, a recent UBS report found that the average acquired business in 2018 had a reported debt-to-EBITDA multiple of 5.6x. But this rose to 7.4x once add-backs were excluded. Similarly, data from the Bank of England’s Prudential Regulation Authority suggest that, once leverage ratios are adjusted to eliminate add-backs, the share of new lending with leverage greater than 7x – a threshold of very high indebtedness – would rise from 18% to 28%.

Given the trend increase in the use of these practices, overall business sector indebtedness may be considerably greater than it first appears.


Three main conclusions can be drawn from this analysis of business debt:

  1. While there are structural reasons why debt should be higher today than in the past, a high level of indebtedness is still a cause of concern because it is an “automatic destabiliser” for the wider economy;
  2. While business sector finances in aggregate don’t look alarming in most major economies, we are concerned about business finances in Canada, Turkey and – most importantly in terms of risks to the world economy – China;
  3. Credit risk – and ultimately financial sector risk – has risen in advanced economies largely due to the deteriorating quality, rather than an unprecedented quantity, of debt.

So, even though the overall corporate sector is not about to buckle under the weight of its debt, there are clearly parts that look vulnerable to a big drop in corporate profits or surge in borrowing costs. The greater the virus-related disruption, the closer we will get to this tipping-point.

  1. While “business” and “corporate” sector are often used interchangeably, they are different according to some definitions. In this Focus, we are interested in the whole non-fin. business sector, not just incorporated firms.

  2. Rendigs Fels (Journal of Political Economy, 1952) “The American Business Cycle of 1879-85”

  3. Net debt of DM non-financial publicly listed companies has grown at a fairly steady pace during most of the past decade. So, the scenarios assume this trend increase in debt continues. The cost of servicing debt for PLCs, perhaps counter-intuitively, has not risen during previous downturns. In fact, declines in risk-free interest rates have typically outweighed the effect of wider credit spreads on the aggregate cost of corporate borrowing. Indeed, at the global level, the effective interest rate on outstanding non-financial corporate debt (annualised interest expense/debt) has fallen during downturn episodes. Despite this, we assume that the effective interest rate would be unchanged, rather than fall, in each of the downturn scenarios.

Simon MacAdam, Global Economist, +44 20 7808 4983,