The brightest minds on Wall Street say companies are sitting on a ticking time bomb that could spark a rash of bankruptcies — and make the next recession even worse

trader yell shout angry

  • A record portion of the investment-grade bond market is sitting
    just one step above junk status.
  • If the credit ratings of those companies fall at all, it would
    greatly increase their likelihood of default. And if a rash of
    firms default at once, it would put serious pressure on the market,
    possibly amplifying any imminent recession.
  • Experts at the recent Milken Institute Global Conference broke
    down their fears around the situation, which are hitting a fever
    pitch.
  • Visit Business
    Insider’s homepage for more stories.

If you see a major corporate acquisition in the headlines today,
there’s a good chance it was financed by debt.

That’s because we’re in the middle of a period marked by some of
the easiest borrowing conditions in history. Rates have been near
rock-bottom levels for the past decade, and companies have been
wise to take advantage.

But this seemingly unlimited spigot of capital has led to some
potentially negative consequences. And the chorus of experts across
Wall Street stressing caution has grown ever-louder.

The focus of their worry is firmly placed on the companies that
make up the investment-grade
section of the corporate bond market. While the debt held by those
firms is considered relatively safe and at low risk of default, the
group’s overall quality has declined over time.

Read more:
‘The disruptors will be disrupted’: The man who runs the $100
billion SoftBank Vision Fund offers bold predictions for how
different the world will look in 10 years

This can be seen by the unprecedented number of bonds sitting on
the lowest rung of investment grade: BBB. As of right now, they
make up the roughly 50% of the investment-grade market, the biggest
share in history. In fact, their presence has doubled in size over
the past 10 years.

Bond ratings

Since that debt is already sitting on the precipice of being
labeled high-yield — or junk — it’s especially vulnerable to
any shift in market conditions that would make it more difficult to
service debt. Whether that change is a simple economic slowdown or
a full-blown recession, risks are mounting as the current cycle
pushes further into its later stages.

The potential fallout could be swift and punishing. Bonds
clinging to their investment-grade status could see their ratings
downgraded into junk territory. That, in turn, would make it harder
for them to pay back their loans, and possibly even default. Once
that happens, bankruptcy might not be too far off.

This swelling portion of bottom-tier investment-grade bonds was
actually a hot topic at the recent Milken
Institute Global Conference
. Whether it was during panel
discussions or one-on-one interviews, Wall Street’s foremost market
experts were clearly perturbed by the developing — and
potentially catastrophic — situation.

Read more:
The world’s greatest investors and economists spent much of Milken
dispelling 3 key misconceptions. Here’s what they said to set the
record straight.


Bryan Whalen
, group managing director of US fixed income at the
TCW Group, told a panel audience that his biggest fear right now is
the debt-to-growth imbalance he sees worldwide.

He highlighted the current debt-to-global-GDP ratio of 220%. In
the US, Whalen is focused on the debt-to-Ebitda ratio, which sits
at a whopping 46%. According to his analysis, any time that ratio
has exceeded 40% over the past 35 years, the high-yield corporate
default rate spiked over 10% within 24 months.

“We see a solving of that imbalanced ratio not by growing our
way out of it, but by writing down that debt,” Whalen said. “Credit
agreements look like Swiss cheese to us.”

Meanwhile, Scott
Mather
— the chief investment officer of US core strategies
at Pimco — had a much simpler take on the precarious situation
facing the BBB class of bonds.

“When those tip into junk, it’ll be a mess,” he told Business
Insider, lamenting the “riskiest
corporate market we’ve ever had
.”

Read more:
An investment chief overseeing $100 billion at Pimco says beware of
the ‘riskiest corporate market we’ve ever had’ — and offers these
strategies for surviving the next recession

So what could ultimately cause a mass exodus from BBB and into
high yield? Answers at Milken were mixed, but one common response
was some sort of major credit event.


Lori Heinel
, the deputy chief investment officer of State
Street Global Advisors, said the US market actually faced a huge
risk recently.

“We
dodged a bullet with PG&E
, because they went from
investment grade straight into bankruptcy, bypassing many steps,”
she told Business Insider. “That kind of large issuer credit event,
by definition, could be destabilizing.”

She continued: “We don’t believe there’s any sort of systemic
credit risk — there are no imminent debt cliffs — but if you
get some sort of high-profile default, that could be
something.”

Todd Jablonski, the chief investment officer at Principal Global
Investors, agreed that it will take some sort of high-profile event
to fully disrupt the bond market. He noted the swelling class of
“zombie” companies that levered themselves to the gills when they
could, and are now “dated and under assault.”

“You’ll eventually get some exogenous force that could disrupt
the Fed and create additional pressure,” Jablonski told Business
Insider. “That would lead to default coming out of the high-yield
space. We’re underweight high-yield.”

Read more:
The investment chief at America’s 2nd-biggest pension fund warns
markets are foolishly overlooking climate change — and paints a
stark picture for the future

However, none of this directly addresses the elephant in the
room: a possible recession. While recessionary cries have softened
in recent weeks, it’s still very much a tail-risk scenario for
experts across Wall Street.

But don’t expect mass credit-rating downgrades to lead to a
recession. If anything, the ticking time bomb in BBB bonds will
exacerbate an economic meltdown, not cause one. After all,
companies’ ability to pay back the debt in question won’t be
affected until the economy is already slowing.

“Eyes wide open, these companies made the choice to increase
their leverage levels, which is a different thing than us being
hopelessly to indebtedness on an ongoing basis,” Nathan Sheets,
the chief economist at PGIM Fixed Income, told Business
Insider.

He continued: “That BBB downward ratings migration is more
likely to be an amplification mechanism of a recession, rather than
a driver of one.”

SEE ALSO: One
expert says an imminent 65% stock-market crash would be
‘run-of-the-mill’ — and explains why risks are greater now than
during the tech bubble


Join the conversation about this story »

NOW WATCH:
This video shows the moment Sarah Sanders lied to a room full of
reporters about FBI agents telling her they were happy Trump fired
Comey

Source: FS – All – Economy – News
The brightest minds on Wall Street say companies are sitting on a ticking time bomb that could spark a rash of bankruptcies — and make the next recession even worse