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Corporate debt seen ballooning to $75 trillion: S&P

Corporate debt is projected to swell over the next several years, thanks to cheap money from global central banks, according to a report Wednesday that warns of a potential crisis from all that new, borrowed cash floating around.

By 2020, business debt likely will climb to $75 trillion from its current $51 trillion level, according to S&P Global Ratings. Under normal conditions, that wouldn't be a major problem so long as credit quality stays high, interest rates and inflation remain low, and there are economic growth persists.

However, the alternative is less pleasant should those conditions not persist. Should interest rates rise and economic conditions worsen, corporate America could be facing a major problem as it seeks to manage that debt. Rolling over bonds would become more difficult should inflation gain and rates raise, while a slowing economy would worsen business conditions and make paying off the debt more difficult.

In that case, a "Crexit," or withdrawal by lenders from the credit markets, could occur and lead to a sudden tightening of conditions that could trigger another financial scare.

"A worst-case scenario would be a series of major negative surprises sparking a crisis of confidence around the globe," S&P said in the report. "These unforeseen events could quickly destabilize the market, pushing investors and lenders to exit riskier positions ('Crexit' scenario). If mishandled, this could result in credit growth collapsing as it did during the global financial crisis."

In fact, S&P considers a correction in the credit markets to be "inevitable." The only question is degree.

The firm worries that investors have been overly willing in their hunt for yield to buy speculative-grade corporate debt. This has been true not only in the United States but also China, which has used borrowing to spur growth but now finds itself at an economic crossroads.

"Central banks remain in thrall to the idea that credit-fueled growth is healthy for the global economy. In fact, our research highlights that monetary policy easing has thus far contributed to increased financial risk, with the growth of corporate borrowing far outpacing that of the global economy." -S&P Global Ratings

Despite the debt boom, central banks have been loathe to put on the brakes. Interest rates remain low around the world, generating a boom in both corporate and government debt, with nearly $12 trillion of the latter now carrying negative yields.

"Central banks remain in thrall to the idea that credit-fueled growth is healthy for the global economy," S&P said. "In fact, our research highlights that monetary policy easing has thus far contributed to increased financial risk, with the growth of corporate borrowing far outpacing that of the global economy."

Between now and 2020, debt "flow" is expected to grow by $62 trillion — $38 trillion in refinancing and $24 trillion in new debt, including bonds, loans and other forms. That projection is up from the $57 trillion in new flow S&P had expected for the same period a year ago.

As the debt market reaches its limits, the firm believes the most likely scenario is an orderly drawdown. However, that projection faces risks.

"Alternatively, a worst-case scenario comprising several negative economic and political shocks (such as a potential fallout from Brexit) could unnerve lenders, causing them to pull back from extending credit to higher-risk borrowers," the report said. "Indeed, the credit build-up has generated two key tail risks for global credit. Debt has piled up in China's opaque and ever-expanding corporate sector and in U.S. leveraged finance. We expect the tail risks in these twin debt booms to persist."

There's a significant risk in credit quality.

Close to half of companies outside the financial sector are considered "highly leveraged," which is the lowest category for risk, and up to 5 percent of that group has negative earnings or cash flows. There already have been 100 debt defaults in 2016, the most since the financial crisis for the period.

S&P worries that investors, particularly those that have bought bonds with longer duration in an effort to get higher yield, are at risk.

"Favorable financing conditions, such as abundant debt funding and low interest rates, have elevated prices for financial assets as investors searched for yield," the report said. "This creates conditions for greater market volatility over the next few years due to lower secondary-market liquidity, with credit spreads for riskier credits and longer duration assets being most exposed."

China is expected to account for the bulk of the credit flow growth, with the nation projected to add $28 trillion or 45 percent of the $62 trillion expected global demand increase. The U.S. is estimated to add $14 trillion or 22 percent, with Europe adding $9 trillion, or 15 percent.