Behind every great crisis is a great expansion or credit bubble. If you glance back at history this pattern readily emerges—expansions and credit bubbles are the one central theme apparent throughout U.S. crises. This happens because “investors, companies and institutions are encouraged to borrow money and speculate the cost of money is cheap,” said Jim Puplava in a recent interview on Financial Sense Newshour. So what happens next?
Puplava explained, “Leverage increases, investors throw caution to the wind believing the good times will go on forever, which they never do.” As the pattern typically goes, sooner or later banks reverse course and switch from cheap money to raising interest rates and tightening credit, and this, Puplava said, is when the credit bubble bursts and the crisis begins.
This time around, investors should be aware of potential problems in the corporate debt market with Bloomberg recently reporting that a corporate debt crisis could come as early as this year. They noted that secure debt isn’t as secure as it used to be and top-heavy capital structures and loose covenants could leave little for junior creditors to recover if an issuer goes bust. Additionally, distressed debt indexes are now showing negative returns for the year, also creating potential bargains. This Bloomberg article along with a recent report by the OECD, point toward a coming corporate debt crisis.
In 2018, BBB-rated debt went from 30 percent of investment grade bonds to 54 percent by the end of the year. Puplava said people tend to gravitate toward investment grade bonds because while they may pay a little less, they’re considered to be more safe. The problem, Puplava said, “is much of that investment grade bond is BBB-rated debt which is just one notch above junk status, but enough to make it investment grade and that’s what a lot of these funds are sitting on.”
The OECD report identified a clear downward trend in overall bond ratings since the 1980s. This is concerning in that a prolonged decline in bond quality could lead to higher default rates in the next downturn. Another key point of the report, especially if you’re an investor, Puplava pointed out, is that bond protective covenants have declined considerably since 2008. This resulted in a narrowing of protective covenants between investment and non-investment grade bonds.
Covenants are important, Puplava explained, because they help to protect the investor, or the individual loaning the money. So when covenant restrictions like debt coverage ratios, limitations on issuing new debt and paying out dividends are removed, it allows lower quality companies to avoid defaulting for a longer period of time.
These are only a few of the issues facing the U.S. corporate bond market. The real problem, Puplava said, is that you have Fed officials saying there’s no need to worry about the banking system, but that’s not where the problem is this time. Every crisis plays out a little differently, but, again, every great crisis has a great expansion or credit bubble behind it. Puplava warns: “last time it was in the banking system with mortgages, this time [the crisis] is in the corporate bond market.”
To listen to Puplava’s recent podcast on Financial Sense Newshour, click here for audio. Listeners can also subscribe in iTunes, Stitcher, and elsewhere.