Despite ample warning signals, equity and bond markets seemed shocked by the recent announcement by General Motors that it expected a first quarter loss. The danger signals included a steep decline in January car sales and an anemic pick-up in February, even though financial incentives of near-record levels were available. Another danger signal was the remarkable news in January that Lehman Brothers was changing the rules governing its investment grade corporate bond index. The firm added a third rating agency (Fitch to Moodys and S&P) and essentially rigged it so that only two of the three had to rate a companys bonds as investment grade (BBB). Since October 2003 both Moodys and S&P had to rate a bond as investment grade for it to be eligible for that index. This was widely acknowledged to be predicated by the fear that GM bonds were threatened with a downgrade to junk bond status, and by the rise in yields of existing GM securities to nearly junk bond yield levels. Moreover, in the minutes to the FOMCs December meeting Federal Reserve officials called attention to signs of speculative activity in corporate bond markets that had driven credit-quality yield spreads relative to US Treasury obligations down to some of the narrowest in years. Finally, the quarterly national income statistics have long pointed to the continuing massive operating losses by the motor vehicles and parts industry. The well-advertised liquidity problems of auto parts supplier Tower Automotive, followed by its February 2 filing for bankruptcy protection under Chapter 11, would have alerted investors to the troubles brewing in the industry. Only the profitable activities of captive finance companiesGMAC in the case of General Motorshave kept overall results of several companies in the auto industry in the black.
The natural question is how vulnerable is the American bond market in the aftermath of the GM announcement and the possibility that other companies may be next. Some important insights can be squeezed out of the recently released Flow of Funds Accounts of the Federal Reserve. Here are some of the highlights.
How big is the corporate bond market?
The market value of bonds issued by nonfinancial corporate business was $2,947 billion at the end of 2004, up from $2,869 the year before. Domestic financial sectors had issues outstanding totaling $3,896 billion at that time, as compared with $3,369 billion at end-2003. Bond issues of commercial banking organizations in the US had a market value of $438 billion. Finance companies, including GMAC for instance, had outstanding bonds valued at $828 billion. Most of the remainder of what the Fed defines as corporate bonds reflects the obligations of issuers of private asset backed securities. They amounted to $2,078 billion at year-end 2004. That is up from $1,774 billion at the end of 2003, a rise of 17%. Most of that increase represents private mortgage-backed securities, which climbed sharply in a year when Fannie Mae and Freddie Mac activities came under intense regulatory and market scrutiny and their own mortgage pool securities grew a miniscule 1.5%.
What fraction of total liabilities of nonfinancial corporations are represented by outstanding bond issues?
Credit market instruments totaled $5.2 trillion at end-2004. So the market value of bonds were 57% of the total, as compared to just half of the total back in the year 2000. Mortgages on commercial real estate came to $688 billion. Bank loans, exclusive of mortgages, were $580 billion at that time, or about 12% of total credit market liabilities. Nonfinancial corporations borrowed almost as much from finance companies as they did from banks, often through leases of equipment or airplanes. Nonfinancial commercial paper used to be a significant source of financing (e.g. with outstandings of $278 billion back in 2000) has dwindled to only about $100 billion, reflecting competition from other sources of finance.
How does the bond debt compare with the equity value of US nonfinancial corporations?
As of end-2004, the market value of equities was $10,844 billion. So the bond debt to equity ratio came to 27%. All credit market liabilities amounted to about half of the market capitalization of nonfinancial corporations.
Who owns the bonds of US nonfinancial corporations?
It isnt possible to tell from the Feds statistics. That is because issues of nonfinancial corporations are aggregated with those of financial institutions, including asset backed securities issuers. The principal domestic holders of securities in the broad market so defined were insurance companies, mutual funds, commercial banks, and households. But the leading holder was the category called rest of the world. As of end-2004, foreign investors held about a quarter of all corporate bonds. They own an even higher proportion of marketable US Treasury obligations, $1,870 billion out of $4,372 billion or about 43%.
What about the debt-servicing burdens of American corporations?
They are generally declining. In Q4 2004, the ratio of net interest and miscellaneous payments of $542 billion to corporate profits with inventory valuation adjustment of $958 billion was 57%. By comparison, at the trough of the 2001 recession it was 79%. The combination of strong economic growth plus the tax breaks for business under the Bush fiscal stimulus program has left most firms in better shape. Naturally that is not the case for specific companies and specific industries. As a result, the number of corporate bankruptcies has not declined as much as in previous expansions and the number of credit upgrades by the ratings agencies has also lagged. In other words, the averages look better but the distribution of credit quality has widened. That widening, however, has not at all been reflected in relative yield spreads in the marketplace, as the statement of concern in the minutes of the FOMCs December meeting indicated.
Final question: Is the possibility of financial difficulties of one or more major corporations sufficient to deter the Federal Reserve from tightening more aggressivelyor at all?
It depends on the state of the economy and of the financial markets. But it is undeniable that if the financial shock is deemed to be systemic in character, the Fed can abruptly shift from tightening to easing monetary policy to prevent instability. The most recent example was in 1998, when the hedge fund Long Term Capital Management got into grave difficulty and the Fed determined that there was a profound threat to the stability of the markets as a whole. The Fed also eased policy dramatically after the 1987 stock market break and after 9-11. Under current circumstances, the most likely result would be for the Fed to move to an even more measured pace of tightening, holding the federal funds rate steady for a period of time, rather than tightening further, in order to assess the market consequences of such financial difficulties. It is unlikely to have done much formal contingency planning, however, for fear that it would leak out and precipitate the very crisis it would seek to avert. And in the very week after the GM announcement of a prospective loss, the Fed raised the federal funds rate another quarter of a percent to 2 ¾%. So the likelihood of being deterred by credit problems is quite low, at least for now.