Board of Governors of the Federal Reserve System

Debt owed by businesses has grown over the long expansion. This growth has pushed nonfinancial business debt—measured as a share of business assets or, more broadly, as a share of gross domestic product—close to the highest levels experienced over the past 20 years. While this situation presents risks, the resilience of institutions at the core of the financial system is much greater than pre-crisis.

Elevated business debt, easy lending standards, and strong risk appetite pose a vulnerability...

Although the increase in nonfinancial business debt has been broad based across most sectors of the economy, it has become increasingly concentrated among the riskiest firms. Detailed balance sheet information of publicly traded nonfinancial firms reveals that, over the past two years, the firms with the most rapid increases in their debt loads have higher leverage, higher interest expense ratios, and lower cash holdings.

Alongside these developments, standards and terms on business debt have continued to deteriorate. Although recent data from the Senior Loan Officer Opinion Survey on Bank Lending Practices indicate little change in lending standards for commercial and industrial (C&I) loans, banks had been easing these standards over much of the past two years. The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody's Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.

In the bond market, the ratings distribution of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, with the share of high-yield bonds outstanding that are rated deep junk (B3/B- or below) declining slightly from its recent peak level of roughly 30 percent reached in 2016.

In contrast, the distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion. A significant weakening in the economic outlook likely would trigger some downgrades of these bonds to speculative-grade ratings and possibly cause some investors to look to sell them rapidly. Given the smaller size of the market for junk debt, a large volume of such sales into a relatively illiquid market could amplify price declines.

...that potentially increases the downside risk to broader economic activity

The historically high level of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors. The most risky firms are also the ones most likely to be financially constrained. Hence, their investment and employment are particularly vulnerable to a widening in corporate debt spreads and a tightening in lending standards. Even without a sharp decrease in credit availability, any weakening of economic activity could boost default rates and lead to credit-related contractions to employment and investment among these businesses. Moreover, existing research suggests that elevated vulnerabilities, such as excessive borrowing in the business sector, increase the downside risk to broader economic activity.¹

Exposures of financial institutions to business debt can amplify losses

The degree to which strains among corporate borrowers are amplified by the financial sector during an adverse scenario depends in part upon the exposure of financial institutions to losses from loans to these borrowers and the associated second-round effects of corporate distress.

The largest components of the $9.7 trillion nonfinancial corporate credit outstanding are corporate bonds (about $5.5 trillion), bank C&I loans (about $1.2 trillion), and leveraged loans (about $1.1 trillion).² Corporate bonds are held by a range of domestic and international investors and firms; among regulated domestic intermediaries, bonds are primarily held by insurance companies or via mutual funds (see figure).³ C&I loans, which include the drawn portion of credit lines as well as term loans, are held on bank balance sheets, while leveraged loans are mainly held via mutual funds and in collateralized loan obligations (CLOs). CLOs are securitized products that, in turn, are held by a range of investors. Based on the limited data currently available, investments in CLOs are spread roughly evenly across domestic and foreign banks, insurance companies, mutual funds, and other investors. The largest domestic banks hold about $90 billion. The composition of CLO investors varies substantially by tranche. For example, roughly one-half of the newly issued triple-A-rated CLO tranches are held by foreign and domestic banks, while the more risky tranches are primarily held by asset managers, insurance companies, hedge funds, and structured credit funds.

Corporate Debt, by Type of Debt and Holder

However, key institutions appear resilient...

A slowdown in economic activity could result in an increase in default rates, which would lead to elevated credit losses at financial institutions holding corporate debt, especially given the reduced amount of covenant protection on leveraged loans. Higher default rates and losses could also materialize through a sharp repricing of credit risk, which would lead to an increased debt service burden on firms with financing needs.

Among U.S. financial institutions, insurers are the largest investors in corporate bonds. One risk related to insurance companies' exposure to business debt is that credit rating downgrades of corporate bond holdings would lead to higher capital charges, which could prompt insurers to liquidate portions of their portfolios, potentially generating spillover losses to the broader market. Relatedly, a large increase in credit spreads would reduce the market value of those holdings. In addition to being large holders of corporate bonds, insurance firms have also increased their investments in CLO tranches steadily since the crisis, in part because CLOs receive favorable capital treatment for insurance companies. Despite these potential vulnerabilities, insurance companies appear resilient. Regulatory capital ratios for insurance companies remain high, and leverage for both property and casualty insurance firms and life insurance companies is low.

Banks are important sources of funding for businesses and, as a result, face exposure to credit risk through C&I loans, leveraged loans, and CLOs held on their balance sheets. Large banks, in particular, face additional risk given their central role in the leveraged loan market. For example, pipeline risk arises between the time when a bank commits to underwrite a leveraged loan and the time when it sells portions of the loan to nonbank investors. If market sentiment shifts abruptly, resulting in lower investor demand for these loans, the bank may need to hold a larger portion of the loan on its balance sheet than it expected. Finally, banks may also face indirect exposures because they act as lenders to nonbank financial intermediaries that may, in turn, be directly exposed to elevated losses on leveraged loans.

On the whole, banks appear well positioned to deal with these exposures. The annual stress-test exercises stress a range of participating banks' direct and indirect exposures to shocks from the business sector. The tests require that participating banks have sufficient capital to withstand material losses on these exposures and continue lending. In addition, banks' internal liquidity stress tests and the Liquidity Coverage Ratio requirement incorporate protections against draws on credit lines. With regard to leveraged lending, banks have improved their management of the associated risks—reflecting, in part, the 2013 interagency guidance on leveraged lending—even as underwriting standards have deteriorated over the past decade. Moreover, large banks have improved their management of syndication pipelines.

Investors in CLOs, including insurance companies, banks, and other financial intermediaries, face the risk that strains within the underlying loan pool will result in unexpected losses on higher-rated tranches of the CLOs. The extent of these losses depends on the conservatism of the CLO structure—specifically, the amount of subordinate tranches and equity. Moreover, insufficient market liquidity for CLO tranches could amplify these risks. The secondary market is not very liquid even in normal times, and liquidity is likely to deteriorate in times of stress, which could amplify any price declines.

It is hard to know with certainty how today's CLO structures and investors would fare in a prolonged period of stress. Although the average subordination level of triple-A-rated tranches moved up to 35 percent in 2018, underwriting standards for the underlying leveraged loans have deteriorated, as previously described. Compared with the investment vehicles associated with subprime mortgages in the financial crisis, CLOs are structured in a way that avoids run risk. In particular, they do not rely on funding that must be rolled over before the underlying assets mature, in contrast to other securitization vehicles such as asset-backed commercial paper. Moreover, the investor base for CLOs has become more stable than in the past. CLOs are now predominantly held by investors with relatively stable funding. In contrast, before the financial crisis CLO tranches were commonly held by leveraged structured investment vehicles that relied heavily on short-term wholesale funding.

...although risks of liquidity strains at mutual funds warrant continued monitoring

Open-end mutual funds and exchange-traded funds that hold bank loans or high-yield bonds permit investors to redeem their shares daily, while the underlying assets can take substantially longer to sell. This mismatch suggests that investors may perceive some incentive to redeem their shares early if they think others are likely to try to do the same. Although widespread redemptions on mutual funds other than money market funds have not materialized during past episodes of stress, a sizable wave of such redemptions during a stress event could depress bond and loan prices, raising the cost of funds to businesses.