Corporate debt could drive the next financial crisis

Interest rates are heading higher, and that is likely to put financial markets under strain. Investors and regulators would both dearly love to know where the next crisis will come from. What is the most likely culprit?

Financial crises tend to involve one or more of these three ingredients: excessive borrowing, concentrated bets and a mismatch between assets and liabilities.

The crisis of 2008 was so serious because it involved all three — big bets on structured products linked to the housing market, and bank-balance sheets that were both overstretched and dependent on short-term funding.

The Asian crisis of the late 1990s was the result of companies borrowing too much in dollars when their revenue were in local currency.

The dot-com bubble had less-serious consequences than either of these because the concentrated bets were in equities; debt did not play a significant part.

It may seem surprising to assert that the genesis of the next crisis is probably lurking in corporate debt.

Profits have been growing strongly. Companies in the S&P 500 index are on target for a 25 percent annual gain once all the results for the first quarter are published. Some companies, like Apple, are rolling in cash.

But plenty are not. In recent decades, companies have sought to make their balance sheets more "efficient" by raising debt and taking advantage of the tax-deductibility of interest payments.

Businesses with spare cash have tended to use it to buy back shares, either under pressure from activist investors or because doing so will boost the share price (and thus the value of executives' options).

At the same time, a prolonged period of low rates has made it very tempting to take on more debt. S&P Global, a credit-rating agency, said that as of 2017, 37 percent of global companies were highly indebted.

That is 5 percentage points higher than the share in 2007, just before the financial crisis hit. By the same token, more private-equity deals are loading up on lots of debt than at any time since the crisis.

Matt King, a strategist at Citigroup, points to another factor. Foreign purchases of American corporate debt have dried up in recent months, and the return on investment-grade debt so far this year has been down 3.5 percent.

He compares the markets with a game of musical chairs.

As central banks withdraw monetary stimulus, they are taking seats away. Eventually someone will miss a seat and come down with a bump.