2. Borrowing by businesses and households
Business-sector debt relative to GDP is historically high, whereas borrowing by households remains at a modest level relative to incomes
Overall, vulnerabilities stemming from total private-sector credit have remained at a moderate level relative to the past several decades. However, growth in business debt has outpaced GDP for the past 10 years, with the most rapid growth in debt over recent years concentrated among the riskiest firms. Although debt-financing costs are low, the elevated level of debt could leave the business sector vulnerable to a downturn in economic activity or a tightening in financial conditions. In contrast, the household debt-to-GDP ratio continued to decline, and the growth of household credit has been concentrated among prime-rated borrowers.
Table 2 shows the current volume and recent and historical growth rates of various forms of debt owed by businesses and households.
Table 2. Outstanding Amounts of Business and Household Credit
|Outstanding (billions of dollars)
|Growth, 2018 (percent)
|Average annual growth, 1997–2018 (percent)
|Total private nonfinancial credit
|Total business credit
|Corporate business credit
|Bonds and commercial paper
|Leveraged loans *
|Noncorporate business credit
|Commercial real estate
|Total household credit
Note: The data extend through 2018:Q4. Growth rates are measured from Q4 the year immediately preceding the period through Q4 of the final year of the period. The table reports the main components of corporate business credit, total household credit, and consumer credit. Other, smaller components are not reported. The commercial real estate (CRE) row shows CRE debt owed by both corporate and noncorporate businesses. Total household-sector credit includes debt owed by other entities, such as nonprofit organizations. GDP is gross domestic product.
* Leveraged loans included in this table are an estimate of the leveraged loans that are made to nonfinancial businesses only and do not include the small amount of leveraged loans outstanding for financial businesses. The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. The average annual growth rate shown for leveraged loans is computed from 2000 to 2018:Q4, as this market was fairly small before 2000.
Source: For leveraged loans, S&P Global, Leveraged Commentary & Data; for GDP, Bureau of Economic Analysis, national income and product accounts; for all other items, Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."
Total private credit has advanced roughly in line with economic activity...
Total private-sector credit—that is, credit to businesses and households—has been expanding at a pace similar to that of nominal GDP for about the past half-decade, and this pattern continued in the second half of 2018 (figure 2-1). Accordingly, its ratio relative to GDP has remained roughly flat at levels similar to those in mid-2005, before the period of most rapid credit growth from 2006 to 2007.
Debt owed by the business sector, however, has expanded more rapidly than output for the past several years, pushing the business-sector credit-to-GDP ratio to historically high levels. At the same time, debt owed by households has been growing more slowly than GDP, resulting in a gradual decline in the household credit-to-GDP ratio (figure 2-2).
...but debt owed by businesses is historically high, and risky debt issuance has picked up recently
After growing faster than GDP through most of the current expansion, total business-sector debt relative to GDP stands at a historically high level. That said, in 2018, total business-sector debt grew a bit below its average pace since 2013 (figure 2-3). The sizable growth in business debt over the past seven years has been characterized by large increases in risky forms of debt extended to firms with poorer credit profiles or that already had elevated levels of debt. While growth in these riskier forms of debt slowed to zero in late 2016, it has rebounded more recently, with leveraged loan net issuance more than offsetting a modest decline in issuance of high-yield and unrated bonds (figure 2-4). Issuance of leveraged loans continued at a solid pace in the first quarter of 2019, though refinancing activity has decreased because of the somewhat elevated spreads. A more in-depth treatment of financial stability concerns associated with the historically high level of business debt can be found in the box "Vulnerabilties Associated with Elevated Business Debt."
Vulnerabilities Associated with Elevated Business Debt
Debt owed by businesses has grown over the long expansion. This growth has pushed nonfinancial business debt—measured as a share of business assets or, more broadly, as a share of gross domestic product—close to the highest levels experienced over the past 20 years. While this situation presents risks, the resilience of institutions at the core of the financial system is much greater than pre-crisis.
Elevated business debt, easy lending standards, and strong risk appetite pose a vulnerability...
Although the increase in nonfinancial business debt has been broad based across most sectors of the economy, it has become increasingly concentrated among the riskiest firms. Detailed balance sheet information of publicly traded nonfinancial firms reveals that, over the past two years, the firms with the most rapid increases in their debt loads have higher leverage, higher interest expense ratios, and lower cash holdings.
Alongside these developments, standards and terms on business debt have continued to deteriorate. Although recent data from the Senior Loan Officer Opinion Survey on Bank Lending Practices indicate little change in lending standards for commercial and industrial (C&I) loans, banks had been easing these standards over much of the past two years. The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody's Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.
In the bond market, the ratings distribution of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, with the share of high-yield bonds outstanding that are rated deep junk (B3/B- or below) declining slightly from its recent peak level of roughly 30 percent reached in 2016.
In contrast, the distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion. A significant weakening in the economic outlook likely would trigger some downgrades of these bonds to speculative-grade ratings and possibly cause some investors to look to sell them rapidly. Given the smaller size of the market for junk debt, a large volume of such sales into a relatively illiquid market could amplify price declines.
...that potentially increases the downside risk to broader economic activity
The historically high level of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors. The most risky firms are also the ones most likely to be financially constrained. Hence, their investment and employment are particularly vulnerable to a widening in corporate debt spreads and a tightening in lending standards. Even without a sharp decrease in credit availability, any weakening of economic activity could boost default rates and lead to credit-related contractions to employment and investment among these businesses. Moreover, existing research suggests that elevated vulnerabilities, such as excessive borrowing in the business sector, increase the downside risk to broader economic activity.1
Exposures of financial institutions to business debt can amplify losses
The degree to which strains among corporate borrowers are amplified by the financial sector during an adverse scenario depends in part upon the exposure of financial institutions to losses from loans to these borrowers and the associated second-round effects of corporate distress.
The largest components of the $9.7 trillion nonfinancial corporate credit outstanding are corporate bonds (about $5.5 trillion), bank C&I loans (about $1.2 trillion), and leveraged loans (about $1.1 trillion).2 Corporate bonds are held by a range of domestic and international investors and firms; among regulated domestic intermediaries, bonds are primarily held by insurance companies or via mutual funds (see figure).3 C&I loans, which include the drawn portion of credit lines as well as term loans, are held on bank balance sheets, while leveraged loans are mainly held via mutual funds and in collateralized loan obligations (CLOs). CLOs are securitized products that, in turn, are held by a range of investors. Based on the limited data currently available, investments in CLOs are spread roughly evenly across domestic and foreign banks, insurance companies, mutual funds, and other investors. The largest domestic banks hold about $90 billion. The composition of CLO investors varies substantially by tranche. For example, roughly one-half of the newly issued triple-A-rated CLO tranches are held by foreign and domestic banks, while the more risky tranches are primarily held by asset managers, insurance companies, hedge funds, and structured credit funds.
However, key institutions appear resilient...
A slowdown in economic activity could result in an increase in default rates, which would lead to elevated credit losses at financial institutions holding corporate debt, especially given the reduced amount of covenant protection on leveraged loans. Higher default rates and losses could also materialize through a sharp repricing of credit risk, which would lead to an increased debt service burden on firms with financing needs.
Among U.S. financial institutions, insurers are the largest investors in corporate bonds. One risk related to insurance companies' exposure to business debt is that credit rating downgrades of corporate bond holdings would lead to higher capital charges, which could prompt insurers to liquidate portions of their portfolios, potentially generating spillover losses to the broader market. Relatedly, a large increase in credit spreads would reduce the market value of those holdings. In addition to being large holders of corporate bonds, insurance firms have also increased their investments in CLO tranches steadily since the crisis, in part because CLOs receive favorable capital treatment for insurance companies. Despite these potential vulnerabilities, insurance companies appear resilient. Regulatory capital ratios for insurance companies remain high, and leverage for both property and casualty insurance firms and life insurance companies is low.
Banks are important sources of funding for businesses and, as a result, face exposure to credit risk through C&I loans, leveraged loans, and CLOs held on their balance sheets. Large banks, in particular, face additional risk given their central role in the leveraged loan market. For example, pipeline risk arises between the time when a bank commits to underwrite a leveraged loan and the time when it sells portions of the loan to nonbank investors. If market sentiment shifts abruptly, resulting in lower investor demand for these loans, the bank may need to hold a larger portion of the loan on its balance sheet than it expected. Finally, banks may also face indirect exposures because they act as lenders to nonbank financial intermediaries that may, in turn, be directly exposed to elevated losses on leveraged loans.
On the whole, banks appear well positioned to deal with these exposures. The annual stress-test exercises stress a range of participating banks' direct and indirect exposures to shocks from the business sector. The tests require that participating banks have sufficient capital to withstand material losses on these exposures and continue lending. In addition, banks' internal liquidity stress tests and the Liquidity Coverage Ratio requirement incorporate protections against draws on credit lines. With regard to leveraged lending, banks have improved their management of the associated risks—reflecting, in part, the 2013 interagency guidance on leveraged lending—even as underwriting standards have deteriorated over the past decade. Moreover, large banks have improved their management of syndication pipelines.
Investors in CLOs, including insurance companies, banks, and other financial intermediaries, face the risk that strains within the underlying loan pool will result in unexpected losses on higher-rated tranches of the CLOs. The extent of these losses depends on the conservatism of the CLO structure—specifically, the amount of subordinate tranches and equity. Moreover, insufficient market liquidity for CLO tranches could amplify these risks. The secondary market is not very liquid even in normal times, and liquidity is likely to deteriorate in times of stress, which could amplify any price declines.
It is hard to know with certainty how today's CLO structures and investors would fare in a prolonged period of stress. Although the average subordination level of triple-A-rated tranches moved up to 35 percent in 2018, underwriting standards for the underlying leveraged loans have deteriorated, as previously described. Compared with the investment vehicles associated with subprime mortgages in the financial crisis, CLOs are structured in a way that avoids run risk. In particular, they do not rely on funding that must be rolled over before the underlying assets mature, in contrast to other securitization vehicles such as asset-backed commercial paper. Moreover, the investor base for CLOs has become more stable than in the past. CLOs are now predominantly held by investors with relatively stable funding. In contrast, before the financial crisis CLO tranches were commonly held by leveraged structured investment vehicles that relied heavily on short-term wholesale funding.
...although risks of liquidity strains at mutual funds warrant continued monitoring
Open-end mutual funds and exchange-traded funds that hold bank loans or high-yield bonds permit investors to redeem their shares daily, while the underlying assets can take substantially longer to sell. This mismatch suggests that investors may perceive some incentive to redeem their shares early if they think others are likely to try to do the same. Although widespread redemptions on mutual funds other than money market funds have not materialized during past episodes of stress, a sizable wave of such redemptions during a stress event could depress bond and loan prices, raising the cost of funds to businesses.
1. For evidence linking deteriorating financial conditions to increased downside risk in gross domestic product growth, see International Monetary Fund (2017), "Financial Conditions and Growth at Risk," chapter 3 in Global Financial Stability Report: Is Growth at Risk? (Washington: IMF, October), pp. 91–118, https://www.elibrary.imf.org/doc/IMF082/24427-9781484308394/24427-9781484308394/Other_formats/Source_PDF/24427-9781484320594.pdf; and Tobias Adrian, Nina Boyarchenko, and Domenico Giannone (2019), "Vulnerable Growth," American Economic Review, vol. 109 (April), pp. 1263–89. For similar evidence on risk to unemployment, see Michael T. Kiley (2018), "Unemployment Risk," Finance and Economics Discussion Series 2018-067 (Washington: Board of Governors of the Federal Reserve System, September), https://doi.org/10.17016/FEDS.2018.067. Return to text
2. These numbers do not directly correspond to those presented in table 2. For corporate bonds, the $6.2 trillion reported in the table includes commercial paper, industrial revenue bonds, and other loans and advances. We have excluded these debt instruments because we do not have detailed data on their institutional holders. Similarly, for bank loans, the $1.5 trillion reported in the table includes mortgage loans in addition to the $1.2 trillion in bank C&I loans. Return to text
3. The large portion at the bottom of the stacked bar for corporate debt in the figure consists mainly of foreign investors, pension funds, and other investors specified in the figure note. Return to textReturn to text
Moreover, credit standards for some business loans appear to have deteriorated further...
Credit standards for new leveraged loans appear to have deteriorated further over the past six months. The share of newly issued large loans to corporations with high leverage—defined as those with a ratio of debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) above 6—increased in the second half of last year and the first quarter of this year and now exceeds previous peak levels observed in 2007 and 2014, when underwriting quality was poor (figure 2-5). This apparent deterioration in credit standards notwithstanding, the credit performance of leveraged loans has remained solid, in part reflecting the relatively strong economy. The default rate on leveraged loans edged down in the most recent data to a level near the low end of its historical range (figure 2-6).
...and leverage in the business sector is high by historical standards
The ratio of debt to assets for all publicly traded nonfinancial firms, including speculative-grade and unrated firms, remains close to its highest level over the past 20 years (figure 2-7). In 2018, the firms with the most rapid increases in their debt loads had riskier financialcharacteristics—higher leverage, higher interest expense ratios, and lower cash holdings. At the same time, broader corporate credit performance remains favorable amid a strong economy, and, with interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms (figure 2-8).
In contrast, borrowing by households has grown modestly relative to incomes, and debt owed by borrowers with solid credit histories has largely driven this growth
In the household sector, debt has expanded at a slower pace than GDP in the 10 years since the financial crisis, and this trend has continued in the most recent data. In addition, there has been an ongoing shift in the composition of household debt toward borrowers with higher credit scores. Loan balances (adjusted for general price inflation) owed by borrowers with prime credit scores—who account for about one-half of all borrowers and about two-thirds of all balances—continued to grow in the second half of 2018 and now exceed their pre-crisis levels. In contrast, loan balances for the remaining one-half of borrowers with near-prime and subprime credit scores were essentially unchanged over the past several years (figure 2-9).
Credit risk of outstanding household mortgage debt remains generally low...
Mortgage debt accounts for roughly two-thirds of total household credit. The general shift in the composition of total household debt toward less-risky borrowers is particularly evident in new mortgage extensions and is broadly consistent with stronger underwriting standards relative to the mid-2000s (figure 2-10).
Mortgage loan performance has been solid. The rate at which existing mortgages transition into delinquency has been very low for several years for borrowers who have prime credit scores or whose loans are in programs offered by the Federal Housing Administration and the U.S. Department of Veterans Affairs. In addition, although the data are volatile, the transition rate into delinquency for borrowers with nonprime credit scores showed a marked decline in the most recent data through November and currently stands at the lowest level in the past 20 years (figure 2-11). Delinquency rates for newly originated mortgages, which give us a sense of recent underwriting standards, have also been low.
Moreover, estimates of housing leverage, measured relative to market value or a model-implied value, are at the moderate level observed in the relatively calm housing markets of the late 1990s, suggesting that home mortgages are backed by sufficient collateral (figure 2-12). Similarly, the share of outstanding mortgages with negative equity—mortgages where the amount borrowed on a property exceeds the value of the underlying home—has flattened out over the past year at a very low level (figure 2-13).
...although some households are struggling with debt
The remaining one-third of total debt owed by households, commonly referred to as consumer credit, consists mainly of balances of student loans, auto loans, and credit card debt (figure 2-14). Table 2 shows that consumer credit rose roughly 5 percent last year and currently stands at about $4 trillion.
Household balances on student loan debt increased modestly in the fourth quarter of last year. Delinquency rates on those loans remain high relative to historical standards, although they have been, on balance, moving sideways in recent years. Although the risks posed to the broader financial system appear limited, as the majority of student loans were issued through government programs, the elevated student loan balances and delinquency rates highlight the challenges associated with debt burdens faced by some households.
The continued growth in auto loan balances through the fourth quarter does not appear to have been accompanied by an increase in the share issued to riskier borrowers (figure 2-15). Delinquency rates for subprime auto loans were on the rise for the past few years but seem to be stabilizing, albeit at a high level (figure 2-16).
Household balances on credit card debt are up moderately since the November FSR and now stand at about $1 trillion. While credit card debt growth was strongest among borrowers with prime credit scores, both near-prime and subprime borrowers also increased their loan balances moderately (figure 2-17). Credit card balances owed by borrowers with less than prime credit ratings have trended up in recent years but remain well below their average levels in the years before the financial crisis. The delinquency rate for subprime credit card debt appears to have flattened out in recent quarters at a level that is considerably lower than its average over the past 20 years (figure 2-18).