Download the Schwab app from iTunes®Get the AppClose

Corporate Bond Bubble? Risks are Brewing, but Market Has Near-Term Positives

Key Points
  • The amount of corporate debt outstanding has surged over the years.

  • Despite the rise, there are supporting factors that may prevent corporate bond prices from falling sharply in the near term, like strong corporate earnings and ample liquid assets.

  • Overall, we have a neutral outlook on both investment-grade and high-yield corporate bonds as long as they fit an investor’s risk profile, and we’d caution against overweighting either type of investment if investors are looking for higher yields.

If you’re reading this, you may have already read headlines or news articles about the growing risks in the corporate bond markets—many headlines even contain the word “bubble.” While we do see risks brewing in the corporate bond market, we don’t think investors necessarily need to exit their corporate bond investments in the near term, as there are plenty of factors that can keep the market supported for now.

We’ll let others decide whether this can be labeled a corporate bond “bubble.” In this article we’ll highlight the risks that the recent trends pose, but also discuss some trends that lend support for the corporate bond market in the near term.

Risks in the corporate bond market are rising

Let’s get right to it, and lay out the worrisome trends in the corporate bond market:

  1. The amount of corporate debt outstanding has surged. This generally garners the most headlines, and rightfully so. The amount of nonfinancial corporate debt has jumped to more than $9 trillion as of the first quarter of this year, and the trend remains up. That compares with just $6.4 trillion in nonfinancial corporate debt outstanding one decade ago. While that 41% increase may seem large, keep in mind that U.S. nominal gross domestic product grew by 38% over the 10-year period ending in the second quarter of this year.1

Corporate debt outstanding is now more than $9 trillion

Source: Bloomberg, using quarterly data as of 1Q 2018. FOF Nonfarm Nonfinancial Corp Business Credit Market Instruments Liability (CDNSCBIL Index).

  1. Investment-grade corporate bonds are behind the surge. Although the amount of corporate debt in all ratings categories has generally been rising, the greatest surge has been in the investment-grade market. The amount outstanding of the Bloomberg Barclays U.S. Corporate Bond Index now stands at $5 trillion. That represents a 130% increase from the $2.2 trillion outstanding just 10 years ago.
     
  2. The amount of BBB-rated bonds has grown sharply. Bonds with BBB ratings, using Standard and Poor’s rating scale, or Baa using Moody’s rating scale, make up a much larger share of the investment-grade corporate bond market today compared to years past. Bonds with triple-B ratings now make up 49% of the Bloomberg Barclays U.S. Corporate Bond Index, while 10 years ago they comprised just a third of the index.
     

The amount of BBB-rated corporate bonds has risen
 

Source: Bloomberg, using monthly data as of 8/17/2018. Amount outstanding of BBB-rated corporate bonds in the Bloomberg Barclays U.S. Corporate Bond Index compared to the amount outstanding of the Bloomberg Barclays U.S. Corporate Bond Index (excluding BBB-rated issues).

BBB or Baa ratings are the lowest rung of the investment-grade rating scale, so these ratings imply a greater risk of default than investment-grade issues with higher ratings, like those rated “A” or above.2

This increase in BBB-rated bonds poses two risks to investors. First, investments that track the broad index likely have more credit risk than may be anticipated. Second, bonds rated BBB are just one rung of ratings above “high yield” or “junk” status. High-yield bonds are those with ratings of “BB+” or “Ba1” and below, respectively, using S&P or Moody’s ratings scale. High-yield bonds generally have higher rates of default than those with higher credit ratings. During the next economic downturn, this large share of BBB-rated bonds means that a large number of issues or issuers could be downgraded to “junk” territory.

So what’s been driving these trends? It’s likely due to the low interest-rate environment of the past nine years.  For years after the financial crisis of 2008 and 2009, interest rates and bond yields hovered at or near all-time lows. U.S. corporations took advantage of this phenomenon by issuing more and more debt with low coupon rates. However, notably, much of this is long-term debt.  This helped lower firms’ interest expenses but also helped push back the risk of default. With fewer bonds coming due in the near term, corporations were able to reduce their refinancing risk.

But this does pose a risk in the long run—that mountain of debt needs to be repaid or refinanced at some point. If refinanced, the debt could potentially be refinanced at higher yields. But for now, we think there are plenty of supporting factors that can prevent corporate bond prices from falling sharply over the next six to 12 months.

Near-term positives

Despite the rise in debt outstanding, we think corporations are well positioned to service this large amount of debt, at least in the near term. Corporate earnings remain strong, the U.S. economy is growing, and corporations generally hold a lot of liquid assets on their balance sheets. This has helped keep demand for corporate bonds relatively high, meaning most corporations should continue to make timely interest payments, and repay or refinance their bonds as they come due.

Here are some supporting trends that can help corporations service their debts:

  1. Ample liquid assets. According to data from the Federal Reserve, nonfinancial corporate businesses held roughly $2.6 trillion in liquid assets on their balance sheets—a more than 80% increase from liquid assets held a decade ago. In fact, liquid assets have grown at a faster pace than the amount of debt outstanding.

    So while the increase in corporate debt has been staggering, so too has been the rise in cash and other liquid assets held by those corporations. The amount of nonfinancial corporate debt relative to liquid assets is now at its lowest level since the 1960s, meaning corporations generally have the means to service the large amount of debt. And while the amount of corporate debt outstanding is up 40% over the past decade, liquid assets have actually risen by 80%. We think this improves the ability of corporations to service their debts in the near-term.

     

Growth in liquid assets has outpaced the growth in corporate debt

Source: U.S. Federal Reserve, using quarterly data as of 1Q 2018. Nonfinancial corporate business; liquid assets (broad measure) and Nonfinancial Corporate Business; Credit Market Instruments; Liability, Billions of Dollars, Quarterly, Seasonally Adjusted.

  1. Corporate earnings and the U.S. economy both remain strong. The U.S. economy is still doing well. In the second quarter, the economy grew at an annualized rate of 4.1%, its highest reading since the third quarter of 2014. On a year-over-year basis, the economy grew 2.8% in the second quarter, and that 12-month rate of change has been climbing for the past two years.


Corporate earnings have been strong, as well. In the first quarter of this year, S&P 500® earnings grew by more than 26% on a yearly basis, its highest growth rate since 2010 as corporations were recovering from the 2008-2009 financial crisis. Through August 23, 96% of the S&P 500 companies have reported earnings, and once all firms have reported, expectations are for an annual growth rate of 25%.3

The passage of the Tax Cuts and Jobs Act at the end of 2017 has also helped boost corporate profits and potentially limit default risk in the near term. The drop in the corporate tax rate from 35% to 21% can help boost the cash available for many corporate issuers, while the lower taxes on profits repatriated from overseas means there may be more cash available to pay down debt. However, it still remains to be seen if those available funds will actually be used to pay down debt.

Corporate earnings have been climbing

Source: Thomson Reuters I/B/E/S, as of 8/23/2018. Chart represents earnings growth for companies in the S&P 500. Light blue column at far  right represents expectations of earnings growth for the yet-to-be-completed second-quarter reporting season.

We think that these factors can help prevent U.S. corporate bond prices from falling sharply lower relative to U.S. Treasury yields in the near term.

And despite concerns about the growing amount of debt, the yields that corporate bonds offer relative to U.S. Treasuries are very low, so investors aren’t being compensated well for these growing risks. For now, we suggest a neutral allocation to both investment-grade corporate bonds and high-yield corporate bonds.

What to do now

Given the growing concerns with the corporate bond market, investors should consider the following:

  • Know what you own and make sure your investments match your risk tolerance and time horizon. High-yield corporate bonds are much riskier than investment-grade corporate bonds and should be considered aggressive investments. And remember that even investment-grade corporate bonds do have more risk than U.S. Treasuries, despite their relatively high credit ratings. If your goal is capital preservation and safety, consider the risks that investment-grade bonds offer relative to more conservative investments, like U.S. Treasuries, and consider moving up in quality.
  • Watch the average credit ratings of your investment-grade corporate bond investments. With the proliferation of BBB-rated bonds in the investment-grade market, index-tracking investments like mutual funds or exchange-traded funds (ETF) may have greater allocations to lower-rated bonds than an investor may be looking for. To combat this risk, investors may want to consider funds that have higher average credit ratings than the underlying index, investing in more bonds with ratings of “A” or better.
  • Watch the average duration. A side effect of corporations issuing more and more long-term debt means investors may also be taking on more interest rate risk than expected. Duration is a measure of interest rate risk, or the risk that the price of a bond may fall when its yield rises. Duration is related to a bond’s maturity—all else equal, the longer the bond’s maturity, the higher its duration. The average duration of the Bloomberg Barclays U.S. Corporate Bond Index has climbed to 7.3 years, near its all-time high. Investors in an index-tracking ETF or mutual fund therefore may also be subject to more interest rate risk than anticipated. Today, we prefer an average duration in the two- to five-year range for corporate investments.

 

1 Source: Bureau of Economic Analysis, calculated as change in nominal GDP from the second quarter of 2008 through the second quarter of 2018.

2 Note that both S&P and Moody’s also offers relative ratings within each rating category. With S&P ratings, ratings from 'AA' to 'CCC' may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody's appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. For example, S&P and Moody’s ratings of BBB- and Baa3, respectively, represent the last rung of investment grade.

3Source: Thomson Reuters I/B/E/S, as of 08/23/2017.

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
Eyes on the Horizon: What Could Cause the Next Crisis?
Emerging Market Rout: Is It Over Yet?

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.  Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0818-8DM3)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.