US economy

Corporate debt fear: getting ratioed


Being a central banker requires facility with complex econometrics and calculus. But in remarks made on Monday, Federal Reserve chair Jay Powell used simple ratios to allay fears of a corporate debt-fuelled financial crisis. Companies have loaded up on leverage in the era of loose money. At the same time, Wall Street has, unsurprisingly, conjured up vehicles and securitised products to both meet demand for debt and its thirst for fees. But as Mr Powell pointed out, the most basic measure of riskiness is not growth in absolute debt levels but rather the proportion of cash flow to interest expense.

According to the Fed’s analysis, the ratio of interest expense to ebitda for all companies is now roughly 10 per cent. The more common way of expressing this is the reciprocal, ebitda/ interest of 10 times. This ratio has steadily improved since 2000 when it was under seven times. Even when junk-rated companies are isolated, their interest coverage ratio currently of around 6 times is twice as good as two decades ago. Mr Powell went on to show that the growth in company leverage tracked the general expansion in the economy, which was in contrast to the subprime mortgage explosion 15 years ago. 

The most intriguing part of the evolution of the corporate debt market are the owners of the paper. Leveraged loans, once the province of large banks and insurers, are increasingly originated by nonbank lenders, particularly for smaller companies. And the ultimate owners of risky loans are not deposit-taking institutions but largely “collateralised loan obligations” that bundle the securities for sale to investors. Another key buyer has been mutual funds that allow retail investors to get high yields that leveraged loans (and separately, junk bonds) provide. 

The key question is how these entities will perform when distress and defaults appear. The good news is that the banking sector has protected itself with higher capital. Expect surprises, then, in the next downturn. However the most likely outcome is contained pain, not a panic. 

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