Top-Rated Debt Is Poised to Fall as Leverage Swells

(Bloomberg Gadfly) -- Crises often occur when investors suddenly realize their foolproof investments actually aren't.

That's when individuals rush to withdraw cash, aiming to avoid losses at all costs, their faith in predictable returns shaken profoundly.

It appears just such a spasm may await the $5.7 trillion U.S. investment-grade bond market. While many investors have been treating top-rated company debt as a proxy to government bonds, these notes are becoming less and less creditworthy.

After years of unprecedented debt sales, these big American companies are more leveraged than they've been since 2002, according to data compiled by Morgan Stanley. At the same time, the amount of cash on their books relative to their obligations has declined to near the lowest levels since 2009.

This development is disturbing for several reasons. First, the U.S. is supposedly in the midst of an economic expansion, albeit a historically tepid one. Corporations have been enjoying dropping unemployment and increasing consumer confidence. This is a time when these borrowers have fewer threats to their revenues. And yet they're still selling debt at a much faster pace than they've been able to increase income.

Meanwhile, leverage ratios typically peak in the wake of an economic downturn, when company incomes drop, making it harder for these firms to repay their obligations. This time, however, leverage is climbing as growth accelerates.

As Tad Rivelle, chief investment officer of fixed income at TCW Group, said on Bloomberg Television on March 3, "Should there be a profit slowdown or, indeed, an economic recession, we're probably going to see a massive amount of downgrades to below investment grade."

UBS strategists led by Stephen Caprio and Matthew Mish pile onto these leverage concerns with a few more worries. They note that investment-grade bond funds have less cash than average as heavy new debt sales have eaten up incoming client money, according to a report today. In addition, European and Japanese investors have started withdrawing cash from U.S. credit markets, a trend that may be exacerbated if central banks globally start moving away from their monetary stimulus efforts.

But do most investors seem worried? No. They're pouring billions of dollars into investment-grade bond funds, fueling what's poised to be another year of record-breaking sales.

Investors are accepting the smallest amount of extra yield over benchmark rates in more than two years to own this debt, despite the deteriorating fundamental quality of the bonds they're purchasing.

This also leaves the notes with less of a cushion to buffer against rising interest rates, which is important when the Federal Reserve is tightening monetary policies.

Enthusiasts for this debt would say that another economic downturn is a ways off and that top-rated corporate debt will continue luring domestic and foreign investors alike. After all, while yields are historically low in the U.S., they're still way above those in other developed nations.

But the more investors allow big companies to borrow money for whatever they want, without materially improving their longer term prospects, the more vulnerable to a shakeup this debt becomes.

There will come a time when this ostensibly safe debt doesn't look so safe anymore. And that's going to be a shocking wake-up call for many investors who think they've been stashing their money in a secure place.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

To contact the author of this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.