Since the financial crisis, households and the financial sector have repaired their balance sheets and become more resilient. But amidst this general trend toward greater financial health, there was one brewing source of financial instability: the corporate bond market. The low rate environment encouraged investors to seek out higher-yielding assets, which created two potential vulnerabilities. One major concern is the amount of leverage, or borrowing, done by low-grade firms, some of whom would have otherwise gone out of business in an environment with tighter credit.
Another is extraordinary growth of the BBB debt market. BBB is the lowest level of bonds which are considered investment grade, or somewhat safe. Before the financial crisis the BBB debt market was similar in size to other segments of the investment-grade corporate market. But in the last 10 years it grew to more than $3 trillion, which is over 53% of the investment grade corporate debt market. This market became very attractive to investors because the debt is considered investment grade and offers higher yields. But it is especially risky because a downgrade to junk is much more likely during times of economic distress. A downgrade means these firms would face much higher borrowing costs, see the chart below. It also can mean more turmoil in the market because many holders of the debt, like pension funds, are required to hold investment grade debt and will need to sell their bonds.
No one can predict how bad an economic shock will be. But we can assess how resilient an economy is. In many ways we went into this new crisis with a strong economy, but the size and scope of the corporate bond market is our biggest vulnerability and it shows there are costs to low rates during economic booms.
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