OECD sees rising risks in corporate debt market

Global outstanding debt in the form of corporate bonds issued by non-financial companies has doubled since before the financial crisis and reached record levels at almost US$13 trillion at the end of 2018.

According to a report by the Organisation for Economic Co-operation and Development, global corporate bond issuance averaged $1.7 trillion per year, compared to an annual average of $864 billion during the years leading up to the crisis.

Companies from advanced economies, which hold 79 percent of the total global outstanding amount as of 2018, have seen their corporate bond volume grow by 70 percent, from $5.97 trillion in 2008 to $10.17 trillion in 2018.

The corporate bond market in emerging markets, which is mainly driven by growth in China, reached a total outstanding amount of $2.78 trillion in 2018, nearly four times the level from a decade earlier.

China moved from a negligible level of issuance before the 2008 crisis to a record issuance of $590 billion in 2016, ranking second highest in the world.

The OECD believes that with growing volume, the risks and vulnerabilities in the corporate debt market have also changed significantly compared to the period before the financial crisis.

The share of lowest quality investment grade bonds now stands at 54 percent, a historical high, and there has been a marked decrease in bondholder rights that could amplify negative effects in the event of market stress, the OECD said.

Typically, a decrease in bond quality is a sign that default rates may rise. The report “Corporate Bond Markets in a Time of Unconventional Monetary Policy” found a prolonged decline in bond ratings, which increases the risk that a potential downturn would lead to higher default rates than in previous credit cycles.

In the case of a financial shock similar to 2008, $500 billion worth of corporate bonds would migrate to the non-investment grade market within a year, the OECD report noted, adding that this would lead to forced sales that would be hard to absorb by non-investment grade investors.

The decrease in covenants, contract clauses that are designed to protect bond holders, is another area the OECD considers problematic.

While lower levels of covenant protection may allow companies to escape defaults for longer, the expectation of a company’s default and achievable recovery rates alone could adversely impact investor portfolios.

Moreover, the report said, “historical data shows that low quality covenants have a significant negative effect on recovery rates.”

Over the next three years, non-financial companies will have to refinance about $4 trillion of corporate bonds, an amount that almost equals the size of the Federal Reserve’s balance sheet.

The expansion of the corporate bond market was one of the desired effects of quantitative easing, a monetary policy that will continue to affect the dynamics in the corporate bond market, the OECD said.

Meanwhile, gross borrowings by governments from the bond markets are also set to reach a new record level in 2019, according to the recent OECD Sovereign Borrowing Outlook 2019.