One of the dominant themes in markets today is the vast amount of near-junk grade debt that’s floating around out there. Corporate debt levels are nearly double what they were during the financial crisis, and in terms of corporate debt to GDP, we’re at levels that we last saw at the top of the last two market crashes. That doesn’t bode well for the future health and strength of markets.
It doesn’t help matters that much of that debt is of low quality, BBB-rate. That’s the last step above junk bonds, and it’s an important indicator that many companies issuing debt aren’t in good shape. In fact, some analysts believe that over half of all BBB-rated debt should actually be rated as junk. And since BBB-rated debt makes up over half of all corporate bonds in existence today, we’re looking at trillions of dollars of corporate debt that could get downgraded during the next economic downturn.
For investors, that wave of potential corporate debt downgrades could have major ramifications. Investment funds and financial institutions that are required to maintain holdings of investment-grade debt would have to immediately divest themselves of debt that is downgraded to junk status. The effect on bond markets would be catastrophic, as bonds would have to get dumped, values would plummet, and yields would skyrocket. The entire bond market would get thrown into confusion, and stock markets would go along for the ride.
That isn’t a far-fetched possibility either, as there’s a pretty good chance that many BBB-rated corporations will no longer be able to service their debt in the future. They’re dependent on low interest rates and continued consumer spending, but if one or the other slows or stops, the whole house of cards comes crashing down.
That’s the price corporations will pay for borrowing cheaply in order to buy back their stocks. They have indebted themselves so much that they’re in a hole now that they can’t dig themselves out of.
Hopefully you’re not in the same situation, and can make adjustments to your investment portfolio to minimize your exposure to BBB-rated debt and the effects that corporate debt downgrades will have on investors. The coming corporate bond bloodbath is one reason so many investors are moving into gold. Gold maintains its value in the face of financial crisis better than any other asset. As millions of investors saw during the financial crisis, gold made massive gains while stocks lost over half of their value.
The next financial crisis will likely see the same pattern, benefiting those who had the foresight to invest in gold, while those who put their faith in Dow 30,000 will suffer the consequences as their 401(k) accounts deteriorate. Which camp would you rather find yourself in?