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Low-rated companies are the biggest accumulators of debt, prompting a major credit agency to warn of significant troubles if current conditions deteriorate.
The alert from Moody's Investors Services comes as worries mount over a looming economic downturn. Short-term bond yields have passed their longer-duration counterparts, a trend that often portends recessions.
Should conditions continue to deteriorate, it could mean trouble for companies that are rated at the lower end of the spectrum, a group that rang up $695 billion in new debt during 2018. The danger is that these "B3" companies only need to decline one notch to fall into the lowest rungs of the junk category, which would make their debt loads even more onerous.
"While industry fundamentals for most of these issuers is still solid, any negative change to the outlook could accelerate a contraction in market liquidity and the credit default cycle given the large proportion of these low rated issuers," Christina Padgett, senior vice president at Moody's, said in a research note. "The real challenge will come when these thinly capitalized companies need to refinance in a potentially more punitive rate environment where valuations could also be more constrained"
New issuers in B3 debt comprised 44% of all new paper that came to market in 2018, double the level in 2007, just before the last recession, which saw massive debt defaults when the subprime mortgage market collapsed.
Some of the biggest issuers in 2018, according to Fitch Ratings: Financial & Risk U.S. Holdings ($1.575 billion); Valeant Pharmaceuticals ($1.5 billion); Meredith Corp ($1.4 billion); McDermott Escrow 1 ($1.3 billion) and Cequel ($1.05 billion).
As things stand, the debt markets still offer enough liquidity and company earnings are still strong though diminishing. The level of "cov-lite" loans that offer a low shield of protection for investors is near record levels and has allowed low-rated borrowers a relatively open market.
"However, B3 issuers are particularly vulnerable to earning declines or rising interest rates," Padgett wrote. "Refinancing will become more of a hurdle as spreads eventually widen and economic growth continues to slow. Downgrades to Caa and below will be punitive to many investors."
Much of the B3-rated space consists of companies owned by private equity firms, which are often inclined to use debt to fund operations and growth and have what Padgett described as "aggressive financial policies and less transparent financial disclosure."
However, there are some signs that the group is taking preventive measures against the downturn.
The lower rung of the high-grade universe is "in deleveraging mode," Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, said in a recent note.
"While historically what prompts companies to delever tends to be an economic downturn, this time — due to super-easy global monetary policies — this large segment of issuers reached late stage balance sheets much earlier in the cycle and is forced to make improvements well before the next downturn," Mikkelsen wrote.
Improvements in the sector, he said, could help offset some erosion in the high-grade space.
Still, market participants are bracing for issues.
In a long-term outlook issued Wednesday, bond giant Pimco said it is concerned about valuations and the risks that market structure could become a problem in the years ahead.
"We remain concerned about market structure in credit and the growth of corporate issuance and investor allocation to credit, in contrast to the decline in market liquidity for corporate bonds. The lower liquidity profile means that we think there should be more compensation for credit risk," the Newport Beach, California-based firm said.
Any dislocations, though, would be opportunities, the outlook said, to be providers of liquidity.