Corporate debt credit standards 'deteriorating,' Fed warns

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WASHINGTON — While most financial institutions and markets are strong and show little sign of systemic risk, the amount of debt owed by businesses and the valuations of corporations are elevated and could be a source of concern, the Federal Reserve said Wednesday.

In a financial stability report, the Fed said that of the four broad areas it examined — elevated valuation pressures, excessive borrowing, excessive leverage within the financial sector and funding risks — the biggest worries were around borrowing levels by businesses and historically high equity valuations and investor appetite for risk.

“Valuation pressures are generally elevated, with investors appearing to exhibit a high tolerance for risk-taking, particularly with respect to assets linked to business debt,” the report said. “Borrowing by households has risen roughly in line with household incomes. However, debt owed by businesses relative to gross domestic product is historically high, and there are signs of deteriorating credit standards.”

Private debt overall is only a “moderate” concern, the Fed said, but corporate debt loads have been growing rapidly — particularly at firms “with weaker earnings and higher leverage.” Moreover, credit standards for new leveraged loans “appear to have deteriorated over the last six months” though leveraged loan performance has remained “solid.”

The distribution of corporate debt at the lower end of the investment grade in the corporate bond market is at “near-record levels,” suggesting that a sudden drop in rating quality could create a serious devaluation and potential source of systemic destabilization, the report said.

“As of the second quarter of 2018, around 35% of corporate bonds outstanding were at the lowest end of the investment-grade segment, amounting to about $2.25 trillion,” the report said. “In an economic downturn, widespread downgrades of these bonds to speculative-grade ratings could induce some investors to sell them rapidly, because, for example, they face restrictions on holding bonds with ratings below investment grade. Such sales could increase the liquidity and price pressures in this segment of the corporate bond market.”

The price-to-earnings ratios for many equity stocks has been trending upward since 2012 and are “generally above their median values … despite recent price declines,” the report said. Value growth in commercial and residential real estate, as well as farm land, have also outstripped the long-term average between the second quarter of 2017 and the second quarter of 2018, the report said.

The report quickly spurred Wall Street reform advocates to highlight the need for stronger safeguards and liquidity positions for financial firms. Marcus Stanley, policy director for Americans for Financial Reform, said that the report demonstrates the need for the very safeguards that he says the Fed is proposing to weaken.

“Today’s financial stability report from the Federal Reserve clearly documents that we are at or near the peak of an economic cycle, with inflated asset prices and strong lending growth leading to signs of excessive leverage in the corporate sector," Stanley said. "The peak of the cycle is the time to strengthen financial safeguards, not weaken them. But there is a disturbing gap between the Fed’s analysis and its actions in weakening regulation across a range of areas, including the Volcker Rule, stress tests, and capital requirements.”

The report noted that the largest U.S. banks are “strongly capitalized,” insurance companies have “strengthened their financial position” and the leverage levels of broker-dealers are “substantially below pre-crisis levels.” Funding risks have also been greatly reduced since the financial crisis, the report said, noting that the financial sector holds a greater share of high-quality liquid assets and money market funds have reduced their run risk.

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