Corporate bond issuance has increased 2.5 times over the past ten years, creating a broader and deeper market in many countries. But there are rising risks.
Since the worldwide financial crisis in 2008, total global debt (including household, nonfinancial corporate, and government debt) has continued to rise, growing by three-quarters from $97 trillion in 2007 to $169 trillion in the first half of 2017 in constant exchange rate terms.
In the latest installment of a series of reports on global debt, Rising corporate debt: Peril or promise? The McKinsey Global Institute looks at the growth in one corner of the global debt market: corporate debt. The total debt of nonfinancial corporations, including bonds and loans, has more than doubled over the past decade, growing by $37 trillion to reach $66 trillion in mid-2017, or 92 percent of global GDP. This growth is nearly equal to the increase in government debt, which has received far more attention. In a departure from the past, a large share of the growth in corporate debt has come from developing countries, and in particular China, which now has one of the highest ratios of corporate debt relative to GDP in the world.
Since the financial crisis, many large corporations around the world have shifted toward bond financing because commercial bank lending has been subdued. Annual nonfinancial corporate bond issuance has increased 2.5 times over the past decade, creating a broader and deeper market in many countries.
The development of corporate bond markets is welcome news that could contribute both to the health of financial markets and economic growth. But there are vulnerabilities. The average quality of blue-chip borrowers has declined, growth in speculative-grade corporate bonds has been particularly strong, and bond issuance by companies in China and other developing countries—often denominated in foreign currency—has soared.
Global corporate default rates are already above their long-term average, and the prospect of rising interest rates may put more corporate bond borrowers at higher risk. In a new report, we assess the financial vulnerability of companies that have issued debt, and the outlook for the market.
This online article summarizes key findings of the report. Part 1 of this summary looks at growth in the corporate-bond market over the past decade and sources of risk. Part 2 examines impending record refinancing needs at a time when corporate profits may be past their peak and interest rates may be rising. Part 3briefly explores how banks, investors, and policy makers may need to respond as risks rise in the corporate bull market.
Global corporate bond markets have expanded, but risks are rising in the bull market
Since the crisis, many large corporations around the world have shifted toward bond financing as commercial bank lending has been subdued. Today, 19 percent of total global corporate debt is in the form of bonds, nearly double the share in 2007. Annual nonfinancial corporate bond issuance has increased 2.5 times, from $800 billion in 2007 to $2 trillion in 2017. The global value of corporate bonds outstanding has increased 2.7 times since 2007 to $11.7 trillion, doubling as a share of GDP (Exhibit 1).
Risks have increased in the corporate bond bull market. While the expansion and deepening of global corporate bond markets is good news, there are also signs that creditworthiness of borrowers has declined. This could prompt more defaults in the years ahead as a record amount of bonds come due and as future borrowing costs rise.
Some features potentially leading to higher risks include:
- The average quality of blue-chip borrowers has declined. In the United States, almost 40 percent of nonfinancial corporate bonds are now rated BBB, just one notch above speculative-grade “junk bonds.”
- Growth in speculative-grade bonds has been particularly strong. Globally, the value of corporate high-yield bonds outstanding increased from $500 billion in 2007 to $1.9 trillion in 2017. In the coming five years, and unprecedented amount of these bonds will come due.
- Bond issuance by companies in China and other developing countries has soared. The value of China’s nonfinancial corporate bonds outstanding rose from $69 billion in 2007 to $2 trillion at the end of 2017, making China one of the largest bond markets in the world. Outside China, growth has been strongest in Brazil, Chile, Mexico, and Russia.
Record refinancing over the next five years comes at a time when some companies and sectors may be vulnerable
From 2018 to 2022, a record amount of bonds—between $1.6 trillion and $2.1 trillion annually—will mature (Exhibit 2). Globally, a total of $7.9 trillion of bonds will come due during those five years, based on bonds already issued. However, some bonds have maturities of less than five years and may still be issued and come due during that period. If current issuance trends continue, then as much as $10 trillion of bonds will come due over the next five years. At least $3 trillion of this total will be from US corporations, $1.7 trillion from Chinese companies, and $1.7 trillion from Western European companies.
Will companies be able to repay the principal on these bonds as they come due? Corporate profits are at or near historical highs after three decades of growth, giving many companies ample financial capacity to finance their growing leverage. However, profits are spread unevenly among corporations and have declined somewhat from their highs. The global profit outlook could come under pressure as competition intensifies when new players, especially from developing countries, and entrepreneurial tech-enabled companies come into the frame.
Moreover, rising interest rates could make it more difficult for many borrowers to refinance their debt. Globally, corporate defaults are already above the long-term average of 1.5 percent since 1981, and default rates could rise further as higher interest rates make debt burdens unsustainable. Some companies already are only barely covering their debt service costs, and the share of such companies will rise with higher interest rates.
The share of bonds outstanding issued by companies in major advanced economies with interest coverage below 1.5 (at lower risk of default) is less than 10 percent. However, even in advanced economies, the share of bonds from companies with low interest coverage ratios is much higher in some sectors than the overall average. In the United States, for instance, companies whose interest coverage ratio is below the 1.5 threshold account for 18 percent of the value of bonds outstanding in the energy sector, or $104 billion.
In three large developing economies—Brazil, China, and India—around 20 to 25 percent of corporate bonds are from issuers with an interest coverage ratio below 1.5, putting them at higher risk of default (Exhibit 3).
Looking at specific sectors in these economies, in China one-third of bonds issued by industrial companies and 28 percent of bonds issued by real estate companies are from issuers with an interest coverage ratio below the 1.5 threshold. In Brazil, several sectors, including consumer goods, energy, and industrials, have a large share of bonds issued by companies below the threshold. One-quarter of all corporate bonds at higher risk of default are in the industrial sector. In India, the real estate, healthcare and pharmaceuticals, and materials sectors represent a large share of bonds from companies with interest coverage ratios below the threshold.
In a simulation of a 200-basis-point rise in rates, the share of bonds at higher risk of default in Brazil, China, and India could rise to 30 to 40 percent. The share of bonds at higher risk of default in Brazil might increase from 24 percent currently to one-third of total corporate bonds outstanding. In India, the share could increase to 27 percent from the current level of 18 percent. China’s share of corporate bonds at higher risk of default could rise to 43 percent, or $850 billion, up from $475 billion in 2017.
There is significant scope for further growth in corporate bond markets, but banks, investors, and policy makers need to be prepared to react to bumps in the road ahead
It is uncertain whether the surge in corporate bond markets over the past ten years will continue after the credit cycle turns and interest rates rise. Investors’ appetite for corporate bonds may wane if sovereign bond yields rise, or if corporate defaults continue to mount. Corporate defaults are already above the 30-year average, and we should expect more defaults, particularly among speculative-grade issuers and some companies in developing countries.
On the other hand, there is still a great deal of room for corporate financing to shift toward bonds and away from loans—a shift that is possible without any increase in overall corporate debt levels. Despite growth in the market, the share of bond financing by European companies was still only 17 percent of their total debt in 2016—half the US share. In China, the share of bond financing in corporate debt was only 11 percent in 2016, one-third of the share in the United States. In other words, if companies in Western Europe and China were to match the appetite of US corporations for bond financing, their markets would double and triple in size, respectively.
In order to navigate this new era, banks, investors, and policy makers may need to adjust their approaches:
- Banks: As large companies move toward raising more funding through bond markets, banks will need to shift their focus toward serving small and medium-sized companies and individuals, improving their risk-assessment skills and cost efficiency, and further developing digital capabilities.
- Investors: In the years ahead, investors will need to undertake especially careful due diligence in evaluating corporate borrowers given that in developing countries, in particular, and in some industries, risks are already rising and could rise further if interest rates increase, and financial reporting and corporate governance structures vary.
- Policy makers and regulators: To ensure healthy growth of corporate bond markets, policy makers should consider how to enable bond markets to enter the digital age, encouraging electronic trading platforms, for instance. They should also consider standardizing contracts to enhance transparency and tradability of bonds in secondary markets, as well as improving transparency in financial reporting. Finally, they need to monitor potential systemic risks that stem from corporate bond markets, particularly given that banks may be the main buyer of corporate bonds.