Board of Governors of the Federal Reserve System

2. Borrowing by Businesses and Households

Vulnerabilities from business and household debt remained moderate

On balance, vulnerabilities arising from borrowing by businesses and households were little changed since the November report and remained at moderate levels. For businesses, both the business debt-to-GDP ratio and gross leverage remained at high levels, although they were significantly lower than the record highs reached at the onset of the pandemic. Nevertheless, median interest coverage ratios remained high, supported by strong earnings growth. Recent data show that earnings growth has started to slow for the largest firms. In the event of an economic downturn, sizable declines in corporate earnings could weaken the debt-servicing capacity of firms. Indicators of household vulnerabilities, including the household debt-to-GDP ratio and the aggregate household debt service ratio, remained at modest levels. However, if household nominal income fails to keep pace with higher prices, tighter budgets may make it more difficult to service existing debt. In addition, an economic downturn or a correction in real estate prices remain risks for household credit performance.

Table 2.1 shows the amounts outstanding and recent historical growth rates of forms of debt owed by nonfinancial businesses and households as of the fourth quarter of 2022. Total outstanding private credit was split about evenly between businesses and households, with businesses owing $19.9 trillion and households owing $19.0 trillion. The combined total debt of nonfinancial businesses and households grew more slowly than nominal GDP since the November report, leading to a modest decline in the debt-to-GDP ratio, which moved back closer to the level that had prevailed for much of the decade before the pandemic (figure 2.1). The decline in the overall ratio was driven by a larger decline in household debt-to-GDP ratio compared to the business debt-to-GDP ratio (figure 2.2).

Table 2.1. Outstanding amounts of nonfinancial business and household credit

Key indicators point to little change in business debt vulnerabilities, which remained moderate relative to historical levels

Overall vulnerabilities from nonfinancial business debt remained moderate since the November report, as measures of leverage remained elevated and robust earnings boosted interest coverage ratios. There are some indications that business debt growth has slowed. Nonfinancial real business debt adjusted for inflation declined slightly (figure 2.3). In addition, net issuance of risky debt dropped sharply as institutional leveraged loan issuance turned negative for the first time since 2020 amid rapidly increasing borrowing costs and weaker investor demand driven by elevated uncertainty and market volatility (figure 2.4). Further, the net issuance of high-yield and unrated bonds remained negative. Gross leverage—the ratio of debt to assets—of all publicly traded nonfinancial firms remained high by historical standards, roughly unchanged from the values seen in 2021 and lower than its historical peak in mid-2020 (figure 2.5). Net leverage—the ratio of debt less cash to total assets—continued to edge up among all large publicly traded businesses and remained high relative to its history.

The interest coverage ratio for all publicly traded firms, measured by the median ratio of earnings to interest expenses, retreated from its recent high but nonetheless remained in the upper range of its historical distribution, suggesting that large businesses were able to service their debt (figure 2.6). The absence of significant deterioration in the level of the median interest coverage ratio despite rising interest rates over the past year has reflected the combination of solid earnings and the sizable share of fixed-rate bonds in corporations' debt liabilities.⁵ A higher share of fixed-rate liabilities mutes the pass-through of increased interest rates into debt-servicing costs. That said, earnings have shown some signs of weakness. In the future, a sharper-than-expected slowing or a decline in economic activity could make debt obligations more challenging to meet for some businesses. For riskier firms with a non-investment-grade rating, interest coverage ratios remained below their historical median levels.⁶

The credit performance of outstanding corporate bonds remained strong since the November report. The volume of downgrades and defaults remained low, but market expectations of defaults over the next year rose as investor perceptions of the economic outlook worsened. More than half of investment-grade bonds outstanding continued to be rated in the lowest category of the investment-grade range (triple-B). If a large share of these bonds were downgraded, debt cost would increase when the bonds need to roll over, putting pressure on firms' balance sheets.

Meanwhile, the available data for smaller middle-market firms that are privately held—which have less access to capital markets and primarily borrow from banks, private credit and equity funds, and sophisticated investors—also indicated that leverage declined over the second half of 2022. The interest coverage ratio for the median firm in this category remained high during the same period and was above the level at publicly traded firms. However, an important caveat is that the data on smaller middle-market firms are not as comprehensive as those on large firms.

The credit quality of leveraged loans remained solid through the second half of 2022 but has shown some signs of deterioration. The volume of credit rating downgrades exceeded the volume of upgrades over this period, and default rates inched up for four consecutive quarters, albeit from historically low levels (figure 2.7). The share of newly issued loans to large corporations with debt multiples—defined as the ratio of debt to earnings before interest, taxes, depreciation, and amortization—greater than 5 remained at a historically high level in 2022, indicating stable tolerance for additional leverage among investors in this market (figure 2.8). Rising interest rates, in combination with a potential slowdown in earnings growth posed by the less favorable economic outlook, could put pressure on the credit quality of outstanding leveraged loans, as their floating debt service costs would increase.

Delinquencies at small businesses edged up, but credit quality remained solid

Delinquency rates for small businesses edged up from relatively low levels, but overall credit quality remained solid. Borrowing costs increased in 2022 and now stand a touch higher than prevailing pre-pandemic rates. In addition, the share of small businesses that borrow regularly increased according to the National Federation of Independent Business Small Business Economic Trends Survey but remained low relative to historical levels; the share of firms with unmet financing needs also remained quite low.

Vulnerabilities from household debt remained moderate

Elevated levels of liquid assets and still-large home equity cushions helped households maintain strong balance sheets through the second half of last year. That said, some borrowers remained financially stretched and more vulnerable to future shocks.

Outstanding household debt adjusted for inflation edged up in the second half of 2022 (figure 2.9). While the increase was broad based across the credit score distribution, most of the growth was driven by borrowers with prime credit scores, who accounted for more than half of the total number of borrowers.

Credit risk of outstanding household debt remained generally low

The ratio of total required household debt payments to total disposable income (the household debt service ratio) increased slightly since the November report. This increase means that some borrowers allocated a larger portion of their income to pay the interest and principal on their loans, potentially weakening their ability to withstand shocks to their income. Nonetheless, the ratio remained at modest levels after reaching a historical low in the first quarter of 2021 amid extensive fiscal stimulus, credit card paydowns, and low interest rates. With the increase in interest rates over the past year only partially passed through to household interest expenses, the household debt service ratio could increase further. With the exception of credit card debt, only a small share of household debt is subject to floating rates, which should limit the effect of increased interest rates in the near term. For most other types of household debt, rising interest rates increase borrowing costs only for new loan originations.

Mortgage debt, which accounts for roughly two-thirds of total household debt, grew a bit more slowly than GDP in 2022:Q4. Estimates of housing leverage when measuring home values as a function of rents and other market fundamentals remained flat and significantly lower than their peak levels before 2008 (figure 2.10, black line). The overall mortgage delinquency rate ticked up from a historically low level (figure 2.11), and the share of mortgage balances in a loss-mitigation program remained low. A very low share of borrowers had negative home equity in the last quarter of 2022 (figure 2.12).

New mortgage extensions, which have skewed heavily toward prime borrowers in recent years, declined in the last quarter of 2022 against the backdrop of higher mortgage rates and slower activity in the housing market (figure 2.13). New mortgage loans with low down payments were seen in about half of the newly originated purchase loans in 2022. Such highly leveraged originations, which also tended to have lower average credit scores, remained vulnerable to house price declines, as their equity could quickly become negative. With the share of adjustable-rate mortgages in new home purchases at 10 percent in recent months, the interest rate risk for mortgage borrowers remained limited. That said, the early payment delinquency rate—the share of balances becoming delinquent within one year of mortgage origination—continued to rise.

The remaining one-third of household debt was consumer credit, which consisted primarily of student loans, auto loans, and credit card debt (as shown in table 2.1). On net, inflation-adjusted consumer credit growth increased a bit since the November report (figure 2.14), at a slightly higher pace than GDP. Real auto loan balances ticked up that period, mostly driven by prime borrowers, but balances for near-prime and subprime borrowers also increased to a lesser extent (figure 2.15). The share of auto loan balances in loss mitigation continued to decline and stood at a low level at the end of 2022, but those in delinquent status have increased in the past several quarters, returning to a level that is in line with its history over the previous decade (figure 2.16).

Aggregate real credit card balances continued to increase in the second half of last year (figure 2.17). Rates paid on these balances increased in line with short-term rates over the past year. Delinquency rates have also increased over the same period (figure 2.18). The outsized nature of the increase in subprime delinquency rates in large part is because of a compositional change in the pool of borrowers arising from fiscal support and forbearance programs implemented during the pandemic.⁷

After rising rapidly for more than a decade, real student loan debt declined with the onset of the pandemic. More recently, student loan balances have ticked up.

 

References

 

 5. Only about 5 percent of outstanding bonds rated triple-B and 1percent of outstanding high-yield bonds are due within a year. Return to text

 6. While these firms represent a large share of the number of publicly traded firms (85 percent), their debt constitutes only 35 percent of the total debt in the sector. Return to text

 7. As a result of these programs, many borrowers from the subprime group migrated to the near-prime or prime groups. The remaining subprime borrowers had lower credit scores, on the whole, than the pool of subprime borrowers before the pandemic. See Sarena Goodman, Geng Li, Alvaro Mezza, and Lucas Nathe (2021), "Developments in the Credit Score Distribution over 2020," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, April 30), https://www.federalreserve.gov/econres/notes/feds-notes/developments-in-the-credit-score-distribution-over-2020-20210430.html. Return to text