Fed’s Kaplan calls for vigilance on corporate debt levels

Government regulators should be vigilant about the level, growth and credit quality of corporate debt because those factors could dampen the ability of companies to invest and spend and amplify the severity of any slowdown in economic growth, Dallas Fed President Robert Kaplan said Tuesday.

“An elevated level of corporate debt, along with the high level of U.S. government debt, is likely to mean that the U.S. economy is much more interest-rate sensitive than it has been historically,” Kaplan said in one of his regular essays on the economic outlook.

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008, Kaplan said.
A number of studies have concluded this level of credit could “potentially amplify the severity of a recession,” he noted.

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

Kaplan said monitoring these higher-risk securities was a critical part of his job as a regional Fed president.

“In the event of a downturn, highly indebted companies may be more vulnerable to seeing their credit quality deteriorate, which could negatively impact their capital spending and hiring plans,” Kaplan said.
If it gets bad enough, credit spreads would likely widen, and be a sign of an overall tightening of financial conditions that could lead to a more significant slowing of the economy, he said.
Kaplan also indicated that regulators, even in the wake of the financial crisis a decade ago, still don’t have a complete understanding of the market for nonfinancial debt. A direct lending market for leveraged loans has grown, Kaplan noted, involving many nonbank firms including hedge funds, insurance companies and pension funds.

“It is difficult to obtain precise information about the size of this market,” although there are estimates that it now exceeds several hundred billion dollars, he said.

The Dallas Fed president also noted the market for syndicated leveraged loans — leveraged loans made to highly indebted companies and typically originated by banks and then syndicated to nonbanks including special-purpose vehicles such as collateralized loan obligations, or CLOs, has doubled in size from $600 million in 2008. “CLO loan-credit quality today is estimated to be somewhat weaker than 10 years ago,” he said.