On Nov. 15, 2019, the Board of Governors of the Federal Reserve (the “Board”) released its semiannual Financial Stability Report. The report presents the Board’s current assessment of the resilience of the U.S. financial system. The Financial Stability Report is similar to those published by other central banks and complements the annual report of the Financial Stability Oversight Council, which is chaired by the secretary of the treasury and includes the Federal Reserve board chair and other financial regulators.
The report contains a number of observations and conclusions of interest to participants in the leveraged finance market.
The Board observed that borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid weak credit standards, and it has grown faster than GDP through most of the current expansion. Furthermore, growth of this debt remained strong and was above the growth rate of economic output in the first half of 2019.
The net issuance of riskier forms of business debt — high-yield bonds and institutional leveraged loans — shows some variation in recent quarters but has remained robust overall in 2019.
The Board noted that an indicator of the leverage of businesses — the ratio of debt to assets for all publicly traded nonfinancial firms — is at its highest level in 20 years. Moreover, the leverage ratio among highly leveraged firms — defined as firms above the 75th percentile of the leverage distribution — is close to a historical high. Despite high balance sheet leverage, historically low interest rates have contributed to keeping the ratio of corporate earnings to interest expenses high for the median firm and near the historical median for riskier firms, which are those in the bottom 25th percentile of the distribution of this ratio.
The Board further observed that the volume of debt downgraded from investment grade to speculative grade in 2019 has been close to the average over the past five years. The Board noted that demand for institutional leveraged loans has remained strong and credit standards have remained weak. The share of newly issued loans to large corporations with high leverage — defined as those with a higher than 6:1 ratio of debt to earnings before interest, taxes, depreciation and amortization — exceeds previous peak levels observed in 2007 and 2014, when underwriting quality was poor. Incoming data point to continued strong issuance of leveraged loans in the third quarter of 2019. However, the Board observed that the credit performance of leveraged loans has been solid so far, with low default rates. Nonetheless, the Board cautioned that in an economic downturn, widespread downgrades of bonds and loans to speculative-grade ratings could lead investors to sell the downgraded debt rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate debt markets known already to exhibit relatively low liquidity.
The Board indicated that data on bank lending to financial institutions operating outside the banking sector — such as finance companies, asset managers, securitization vehicles and mortgage real estate investment trusts — can be informative about the use of leverage by nonbanks and shed light on the credit exposures of banks to these institutions. Committed amounts of credit from large banks to nonbanks have nearly doubled since 2013, and reached about $1.4 trillion by mid-2019. To date, about one-half of these committed amounts have been borrowed by nonbanks in the form of term loans or credit-line drawdowns. The outstanding loans to nonbanks represent about 11 percent of total loans of large banks, and the share of loans to nonbanks that are investment-grade loans remains stable at roughly 70 percent. The Board reported that total assets under management in high-yield corporate bond mutual funds and in bank loan funds have more than doubled over the past decade, to about $350 billion. The Board cautioned that the timing mismatch between the ability of investors in open-end bond and bank loan mutual funds to redeem their shares daily and the longer time often required to sell corporate bonds or loans creates conditions that can lead to runs on these funds in times of stress. While bank loan mutual funds continue to experience moderate outflows in 2019, mutual funds have been able to meet those redemptions without significant dislocations to market functioningThe full text of the report can be found here.