THE CORPORATE debt mountain may trigger a devastating, self-feeding chain reaction of fire sales of junk bonds, threatening to collapse the entire financial system, the OECD club of rich nations has warned.
The issuing of corporate bonds has doubled to $13 trillion in the last ten years, with standards deteriorating markedly to the point that many of them have been reduced to ‘junk status’, said the OECD in a report issued this week.
Once cut to junk status these bonds become ‘fallen angels’ and are automatically ejected from high grade borrowing funds.
Borrowing costs then soar and a vicious circle of ‘default contagion’ can ensue, threatening an uncontrollable chain reaction.
The detailed report by the OECD’s corporate finance division, warns: ‘In the case of a downturn, highly leveraged companies would face difficulties in servicing debt, which in turn, through higher default rates, may amplify the effects.
‘Any developments in these areas will come at a time when non-financial companies in the next three years will have to pay back or re-finance about $4 trillion worth of corporate bonds. This is close to the total balance sheet of the US Federal Reserve.’
The report warns that the share of bonds with a BBB (very low debt rating) has risen from 30% in 2008 to 54% today.
‘The downgrade of a large amount investment grade bonds may be hard to absorb by the non-investment grade market and may cause volatility and spreads to rise across the market,’ the report goes on.
It warns that $500 billion of investment grade bonds could collapse into ‘junk’ status within a year of any economic downturn, leading to a ‘cascade’ across the financial system.
It also warns that bond quality has been deteriorating since the 1980s and protection for creditors has been progressively degraded.
And that the ‘easy money’ climate of recent years has led to a false sense of security and that higher interest rates will ‘soon expose the fallacy of this’.