Corporations have been able to borrow heavily at historically low interest rates, facilitated by an unprecedented federal reserve monetary policy that sustained near-0% levels for over a decade. This has allowed companies the ability to leverage debt as a means of rapidly expanding their business operations. However, as that debt becomes due and new debt is issued, those new corporate debt issuances now face not only much higher rates but will likely also face significantly higher credit spread premiums for the risk being taken. My thesis is that the ballooning of corporate debt expirations, particularly in speculative-grade debt and lower-rated investment-grade debt starting in 2025, will lead to significant market instability and job losses.
The Setup: Debt Maturities and Debt Quality
To better grasp the potential contagion that can occur, we first need to look at the amount of debt and the structure of that debt to see just how challenging the future is. According to S&P Fixed Income Research (2022), an estimated $2.18 trillion dollars of debt will have matured by the end of 2023. This amount increases to $2.29 trillion in 2024, followed by $2.32 trillion in 2025 and $2.32 trillion in 2026. On its surface, that doesn’t seem dire – we’re talking about an annualized growth rate of a little over 2% per year.
However, when you begin to examine the quality of that debt, the upcoming maturities look far less benign. In 2023, global speculative grade debt coming due amounted to $388 billion. In 2024, that number jumps to $591 billion, and by 2025 that number is nearing $800 billion dollars (S&P Global Ratings, 2022). Moreover, the amount of maturing debt that belongs to the CCC+ and lower tranche, what is commonly referred to as “junk debt,” will quadruple from 2023 to 2025. These levels continue into 2026, with speculative-grade debt maturities increasing by 118% in the next three years.
The problem with this setup is that unless these speculative companies can pay these debts off, they will likely be facing the need to refinance their debt. However, even companies that are rated BB, the highest grade of speculative debt, possess according to Fitch Ratings “an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time” (Fitch Ratings, n.d.). CCC rated debt is considerably worse, showing “Very low margin for safety. Default is a real possibility” (Fitch Ratings, n.d.). Given the sudden rise of both inflation and interest rates in 2022, these companies are now facing one of the most significant and drastic structural changes in corporate finance in the last fifty years.
The Confrontation: What Do When Debt Due?
Speculative-grade companies by and large are not going to have the liquidity necessary to pay back the debt when it becomes due. They will likely have three options for how to navigate debt maturities as they come due.
- They can pay back the loan in full. This will likely require significant cost cutting, which invariably means shedding head count as means of freeing up cash flow. This will result in layoffs.
- They can attempt to survive and refinance the debt. However, the effective yield of CCC debt has already increased from an effective yield of approximately 7.5% in 2021 to a yield of 13.5% today (Y Charts, 2023). It should be noted that the increase includes not just the 525 basis points from the Fed, but includes another 75 basis points in risk premium on top of that. As more speculative debt becomes due in upcoming years, that risk premium is likely to further increase, even if the Fed does not raise rates again beyond the current range of 5.25%-5.50%. I do not know of a highly successful business model that can survive long-term holding a 14%+ credit card-like level of debt structuring. Those companies that choose to take this path are likely gambling on the Federal Reserve to eventually lower rates, thereby offering an opportunity to refinance; if that does not happen, they are likely forced into cost-cutting, followed by bankruptcy – and layoffs.
- They can figure out over the next two to three quarters that they are a pretender and not a contender, and if that is what they conclude, they can try to find a suitor to buy them. If they are able to accomplish that, the suitor pays off the debt but there is likely duplicity and cost-efficiencies to be found in combining the two companies, resulting in layoffs.
No matter which path is pursued by these speculative grade companies, particularly those in the CCC tranche, layoffs seem like an unavoidable reality.
The Plot Thickens: The U.S. Holds The Bag And The Exposure Is Widespread
According to S&P Global Ratings Research (2023), the United States accounts for 49% of rated debt globally. However, the U.S. also accounts for an estimated $3.2 trillion of speculative grade debt out of the $5.22 trillion that currently exists, representing 61% of the total speculative risk pool (S&P Global Ratings Research, 2023). The nature of this debt is not financing the banking system; 90% of the debt is in nonfinancial corporations (S&P Global Ratings Research, 2023).
While most industries have some representation of speculative-grade debt as there are good and bad companies in every sector, there are some notable sectors that have significantly higher concentrations of risky debt.
- Telecom and high technology companies have an approximate one-third exposure to speculative-grade debt. (Approximately $500 billion in speculative grade)
- Consumer products and restaurants have an approximately 40% exposure to speculative-grade debt. (Approximately $400 billion in speculative grade)
- Health care companies have a nearly 50% exposure to speculative-grade debt. (Approximately $325 billion in speculative grade)
- Media and entertainment companies have an approximately 70% exposure to speculative-grade debt (Approximately $430 billion)
These four sectors alone comprise $1.625 trillion in speculative-grade debt, of which the U.S. owns $1 trillion of, and employs approximately 32 million Americans.
The Twist: The Default Wave Has Already Picked Up Steam, But The Market Does Not Acknowledge It
U.S. issuers of speculative-grade corporate debt have reported a default rate of 3.24% through June 2023, double that of the prior year with a baseline scenario of 4.5% defaults by June 2024 (S&P Global Ratings Research, August 2023). However, more pessimistic scenarios exist, ranging from 6.25% to as high as a 15% default rate on total U.S. corporate debt according to Oleg Melentyev of Bank of America, characterizing the defaults as a “distinct risk” (Sor, 2023). For context, during the 2008 financial crisis the peak default rate on speculative-grade debt was 13%. If a 15% default threshold were to be reached, it is very possible that over $1 trillion in corporate debt could go into default; this would be nearly double the size of debt that went into default during the 2008-2009 financial crisis.
And yet credit issuers are still in la la land. Speculative-grade debt still trades at a spread of approximately 400 basis points (4%), a relative trough compared to periods of stress where spreads exceeded 600 basis points (6%). Plainly speaking, this means that while the risk data exists and is known, there is either enough demand or a broad lack of understanding regarding speculative-grade debt such that the risk premium has not come into play – yet. During the financial crisis, it started in early 2007 with subprime lenders beginning to file for bankruptcy. But it took a year after that for Bear Stearns to fall in March of 2008, and six months after that for Lehman to collapse in September of that year. In an eerily similar comparison, speculative-grade debt traded at multi-year lows throughout much of 2007, picking up steam only as the year came to a close, but only leaping up decisively as Bear Stearns began its collapse. The point is, for all the people looking at what was going on then, few acknowledged that the data they were staring at could be an existential risk for the financial industry – including the people handing out money to fuel it.
The Coup de Grace: What If BBB Debt is Misrated (Again)?
BBB rated debt is the lowest rating offered to debt that maintains the debt quality as “investment grade.” This rating allows companies to borrow at considerably lower rates, namely in part to the quality of their issuances being able to bear the “investment grade” moniker. It seems incredibly unnatural to me that of the $8.57 trillion in investment grade debt, $4.68 trillion of it is specifically rated in BBB. It does not surprise me that the next tranche above – A rated debt – has a pool size of $3.16 trillion. But it is incredibly curious that BB rated debt – the highest tranche of non-investment grade debt – has a pool size of just $1.18 trillion, just 37% of the size of the A rating tranche.
While I don’t expect any particular graph or data dynamic, the fact is that bond issuers pay the agencies to provide ratings, and an inherent conflict of interest exists when the people paying you are the very people whose offerings you are scoring. I have great concern that a fair amount of the A rated debt and a substantial amount of the BBB rated debt are overly optimistic and could hold considerably more risk than the rating itself presents. If that ends up being the case, then we could have yet another situation on our hands where, as a result of a persistently tight interest rate environment, we could see things defaults in tranches that we do not expect, causing a ripple effect into the speculative-grade debt that is already under pressure, thereby making yield spreads rapidly soar resulting in a spike of defaults, much like what happened in 2008.
Conclusion: We Need to Be Individually Prepared For What Collectively May Occur
It is possible and entirely my hope that I am wrong, that what I have laid out here ultimately does not come to pass, that through luck or misunderstanding that nothing bad happens. That said, if a 15% default rate scenario were to occur – and I do believe this is a pessimistic but realistic scenario – the net result could be the loss of $1 trillion dollars with upwards of a net 5-6 million people out of work. The unemployment rate would rise from its current level of 3.8% to as high as 7% over a two-year period. However, I cannot predict which companies and in what direction preventative measures such as mergers and acquisitions will take place – though I do expect those to grow considerably in 2024 ahead of the speculative-grade debt horizon in 2025-2026.
An analogy I believe is apt is to compare this with a large tropical storm that we see on radar hundreds of miles away from our shore. We know it is coming, and we know that it has the potential to be massive and outright devastating, but you still have time to make significant preparations in the event it does landfall. This is the time to make certain cash savings are strong. This is the time to eliminate any high-interest debt off the books. This is the time to make certain you are networking professionally, that your LinkedIn is up to date, that you are generally prepared for a shift in employment and economic environment. It is not a time to live scared or panic, but a controlled preparation and a plan ensures that if I am right, you are prepared, and if I am wrong, that you can take comfort in the strong foundation you will have built for yourself should anything harmful arise in your life. You cannot control what happens “out there” in the banking and corporate world, but you can recognize the risk greed that is likely occurring and build appropriate defenses to defend yourself and your household from whatever outcomes it may bring.
Credit trends: Global state of play: Debt growth diverging by credit quality. (2023, September 6). S&P Global Ratings. Retrieved September 22, 2023, from https://www.spglobal.com/ratings/en/research/articles/230906-credit-trends-global-state-of-play-debt-growth-diverging-by-credit-quality-12835732
Default, transition, and recovery: The U.S. Speculative-Grade corporate default rate could rise to 4.5% by june 2024. (2023, August 7). S&P Global Ratings. Retrieved September 22, 2023, from https://www.spglobal.com/ratings/en/research/articles/230817-default-transition-and-recovery-the-u-s-speculative-grade-corporate-default-rate-could-rise-to-4-5-by-jun-12825499
Global corporate debt maturities through 2026. (2022, January 1). S&P Global Ratings Research. Retrieved September 22, 2023, from https://investorfactbook.spglobal.com/sp-global-ratings/global-corporate-debt-maturities-through-2026/
Rating definitions. (n.d.). Fitch Ratings. Retrieved September 22, 2023, from https://www.fitchratings.com/products/rating-definitions
Sor, J. (2023, May 12). A recession and a credit crunch could result in $1 trillion of corporate debt defaults, Bank of America says. Markets Insider. https://markets.businessinsider.com/news/bonds/recession-credit-crunch-us-economy-debt-default-bank-of-america-2023-5
US High yield CCC effective yield. (2023, September 20). YCharts. Retrieved September 22, 2023, from https://ycharts.com/indicators/us_high_yield_ccc_effective_yield