Board of Governors of the Federal Reserve System

2. Borrowing by Businesses and Households

Vulnerabilities from business and household debt remained moderate

Balance sheets of many nonfinancial businesses and households remained solid, with vulnerabilities at moderate levels. That said, there are increasing signs that higher interest rates are beginning to strain some borrowers.

For businesses, both the business debt-to-GDP ratio and gross leverage remained at high levels, although they were significantly lower than the record highs reached at the onset of the pandemic. Interest coverage ratios (ICRs)—defined as the ratio of earnings before interest and tax to interest expense—moved down in the most recent data but remain solid, suggesting that firms, overall, have sufficient cash flows to cover rising borrowing costs. Indicators of household vulnerabilities, including the household debt-to-GDP ratio and the aggregate household debt service ratio, remained at modest levels. An economic downturn resulting in lower business earnings and household incomes could weaken the debt service capacities of smaller, at-risk businesses with already low ICRs as well as particularly indebted households.

Table 2.1 shows the amounts outstanding and recent historical growth rates of forms of debt owed by nonfinancial businesses and households as of the second quarter of 2023. The combined total debt of nonfinancial businesses and households grew more slowly than nominal GDP in recent quarters, leading to a decline in the debt-to-GDP ratio, which is now at the level that prevailed over most of the past decade (figure 2.1). The drop in the overall ratio was driven in equal parts by declines in both the household and business debt-to-GDP ratios (figure 2.2).

Table 2.1. Outstanding amounts of nonfinancial business and household credit

Business debt vulnerabilities remain moderate relative to historical levels

Overall vulnerabilities from nonfinancial business debt increased slightly since the May report but remained moderate overall. While measures of leverage remained high, debt growth continued to decline. Firms' ability to service their debt, as measured by ICRs, edged down a bit in the most recent data but remained solid owing to resilient earnings. However, risky borrowers' ability to service their debt burdens has started to show signs of weakness, as would be expected in a rising interest rate environment, and could become further strained if corporate earnings fall due to a sharper-than-expected slowdown in economic activity.

The growth of nonfinancial business debt adjusted for inflation declined over the past year (figure 2.3), and net issuance of risky debt—defined as the difference between issuance of high-yield bonds, unrated bonds, and leveraged loans minus retirements and repayments—remained subdued as firms repaid existing leveraged loans at a faster pace than new loans were issued (figure 2.4). The net issuance of high-yield and unrated bonds was also subdued through the third quarter of 2023.

Gross leverage—the ratio of debt to assets—of all publicly traded nonfinancial firms remained high by historical standards (figure 2.5). Net leverage—the ratio of debt less cash to total assets—continued to edge up among all large publicly traded businesses and remained high relative to its history. Meanwhile, firms' ability to service their debt remained solid overall, despite some emerging signs of weakness among riskier firms. The median ICR has been steadily declining from its peak reached during the post-pandemic earnings boom and inched down further in Q2 (figure 2.6). The decline partially reflects modest pass-through of higher interest rates to firms' borrowing costs, because most of the debt issued by large firms carries fixed rates.³ Corporate earnings remained solid for the first half of 2023. However, signs of stress in debt servicing and deterioration in credit quality are emerging for the most vulnerable and lowest-rated firms as elevated borrowing costs begin to weigh on interest expenses.⁴

The credit performance of outstanding corporate bonds remained solid, but signs of deterioration have emerged since the May report. The volume of downgrades and defaults remained low, but realized defaults and market expectations of defaults over the next year have been trending up in recent months as pressures from rising interest rates and economic uncertainty mount. More than half of investment-grade bonds outstanding continued to be rated in the lowest category of the investment-grade range (triple-B). If a large share of these bonds were downgraded, debt cost would increase when the bonds need to roll over, putting pressure on firms' balance sheets.

Small and middle-market firms that are privately held—which have less access to capital markets and primarily borrow from banks, private credit and equity funds, and sophisticated investors—account for roughly 60 percent of outstanding U.S. debt. Available data for these firms indicate that vulnerabilities inched up as higher interest rates started to reduce earnings and raise debt service costs.⁵ Since the last report, leverage for these firms increased slightly following several quarters of post-pandemic declines and is currently roughly in line with leverage levels among publicly traded firms. The ICR for the median firm in this category declined notably but remained at a high level, above that of publicly traded firms.

The credit quality of outstanding and newly issued leveraged loans remained solid through the first half of 2023 but continued to show some signs of deterioration. The volume of credit rating downgrades exceeded the volume of upgrades over this period, and default rates have continued to inch up from their historic lows reached in 2021 (figure 2.7). The share of newly issued loans to large corporations with debt multiples—defined as the ratio of debt to earnings before interest, taxes, depreciation, and amortization—greater than 4 has fallen to its lowest level in the past decade, suggesting limited investor tolerance for riskier loans (figure 2.8). As noted, a potential slowdown in earnings growth posed by the less favorable economic outlook combined with rising interest rates could put pressure on the credit quality of outstanding leveraged loans, as their floating debt service costs would increase.

Delinquencies at small businesses edged up, but credit quality remained solid

Credit quality for small businesses remained relatively solid, though delinquency rates continued to edge up in recent months from relatively low levels. Borrowing costs increased in the first half of 2023 to levels not seen since prior to the Great Recession. In addition, the share of small businesses that borrow regularly declined since the beginning of the year, according to the National Federation of Independent Business Small Business Economic Trends Survey, and was somewhat low relative to historical levels. The share of firms reporting unmet financing needs remained quite low. Loan originations for small businesses remained in line with pre-pandemic levels.

Vulnerabilities from household debt remained moderate

Household balance sheets remained strong overall. Many households that purchased homes or refinanced when interest rates were low continued to benefit from lower interest rate payments, strengthening their current financial position. That said, some borrowers, especially those with newly originated debt as interest rates have increased over the past year and a half, remained financially stretched and more vulnerable to future shocks.

Outstanding household debt adjusted for inflation ticked down in the second quarter, with the decline in the most recent data broad based across the credit score distribution (figure 2.9). The ratio of total required household debt payments to total disposable income (the household debt service ratio) increased slightly since the May report. Nonetheless, the ratio remained at modest levels after reaching a historical low in the first quarter of 2021 amid credit card paydowns with low interest rates at the time. Higher interest rates over the past year have only partially passed through to household interest expenses because, except for credit card debt, only a small share of household debt is subject to floating rates. For most other types of household debt, rising interest rates increase borrowing costs only for new loan originations.

Mortgage credit risk remained generally low

Mortgage debt, which accounts for roughly two-thirds of total household debt, grew a bit more slowly than GDP over the past four quarters. Estimates of housing leverage when measuring home values as a function of rents and other market fundamentals remained flat and significantly lower than their peak levels before 2008 (figure 2.10, black line). The overall mortgage delinquency rate was essentially unchanged in the most recent data after edging up from the historically low levels reached in 2021, and the share of mortgage balances in loss-mitigation programs remained low (figure 2.11). A very low share of borrowers had negative home equity in the most recent data through June 2023 (figure 2.12).

New mortgage extensions, which have been skewed heavily toward prime borrowers over the past decade, continued to decline sharply in 2023 as mortgage rates remained elevated (figure 2.13). The early payment delinquency rate—the share of balances becoming delinquent within one year of mortgage origination—continued to rise from its 2020 low, likely reflecting increasing strains associated with higher interest expenses on newly originated mortgages.

Credit risk of outstanding household debt remained generally low, but borrowers with low credit scores continued showing signs of stress

Consumer debt—which accounts for the remaining one-third of household debt and consists primarily of student, auto, and credit card loans—edged down in real terms since the last report (figure 2.14) and, in nominal terms, increased at a slightly slower pace than nominal GDP. However, delinquency rates on newly issued consumer loans rose, particularly among borrowers with low credit scores, as interest rates continued to rise.

Real auto loan balances ticked up for prime borrowers but declined modestly for near-prime and subprime borrowers (figure 2.15). Smoothing through the quarter-to-quarter variation over the first half of 2023, the share of auto loan balances in loss mitigation moved sideways and remained roughly in line with its historical median. Those in delinquent status also remained essentially flat, although at a level above the historical median (figure 2.16). That said, the aggregate delinquency rates mask a much sharper rise in auto loan delinquency rates for subprime borrowers in the second quarter of 2023, which increased to a level that was elevated relative to where it stood pre-pandemic.

Aggregate real credit card balances continued to increase over the first half of the year, and the increases were broad based across the credit score distribution (figure 2.17). Rates paid on these balances increased in line with short-term interest rates over the past year. However, delinquency rates have continued to increase over the same period (figure 2.18).

After rising rapidly for more than a decade, student loan debt, after adjusting for inflation, began to decline with the onset of the pandemic. Student loan repayments, which had been on hold since March 2020, are set to resume in October.

 

References

 

3. Only about 5 percent of outstanding bonds rated triple-B and 1 percent of outstanding high-yield bonds are due within a year. Return to text

4. While these firms represent a large share of the number of publicly traded firms (85 percent), their debt constitutes only 35 percent of the total debt in the sector. Return to text

5. An important caveat is that the data on smaller middle-market firms are not as comprehensive as those on large firms. Return to text