The debt market could get ugly

Things haven’t been pretty for energy companies that have a lot of debt. Low oil prices have pressured profits and lead to skyrocketing defaults and an ugly state of affairs for energy debt.

The tough times in the debt market won’t be limited to just the energy sector for long, according to Adam Richmond and the US credit strategy team at Morgan Stanley.

“While many believe the problems in credit are predominantly Energy-related, and thus possibly behind us, we think the fundamental weakness in Energy over the past year is just a symptom of the bigger issue,” wrote Richmond in a note to clients.

“Low rates and easy liquidity for years (as well as minimal earnings growth) have driven significant increases in leverage and deteriorating credit quality almost everywhere.”

Richmond cites two interconnected reasons for the coming increase in defaults: historically low interest rates and the booming growth of low-quality debt issuance.

Basically, since interest rates made the cost of servicing debt so cheap, companies have been piling on risky debt to their balance sheet. Add on the appetite for high-yielding assets by income-oriented investors and tightening credit conditions, and you’ve got all the ingredients for a credit default stew.

So Richmond turns to the central question: who is in danger?

Richmond broke down the growth of the overall amount of debt issued by companies and the percentage of total high yield debt issue by firms with equity to debt leverage of 6 times or more in various sectors. He refers to this as the leveraged “tail” in each sector.

In terms of sectors at risk, Richmond identified three big culprits: consumer cyclicals, consumer non-cyclicals, and healthcare.

Despite strong incomes from consumers and increasing spending, Richmond said that the debt taken on by consumer-focused companies is concerning.

“Ex-Commodities, we see heightened risks in Consumer Cyclicals as an example, which accounts for 18% of the growth in the [high yield] bond market in this cycle, and has experienced a large increase in the ‘highly leveraged tail’ since 2011 (in absolute terms),” wrote the strategist.

“Similarly, 27% of the ‘tail’ in the loan universe is made up of Consumer Cyclical companies.”

Healthcare is in similar straits, according to Richmond.

“Outside of Commodities and Consumer Cyclicals, Healthcare accounts for the largest absolute and relative amount of the tail ($51 billion and 59% of sector),” said Richmond.

The biggest problem, however, is that while these sectors are most at risk the entire market has seen a boom in highly levered companies issuing debt. In fact, the amount of debt from companies with 6 times leverage or worse has doubled in the past five years, a $215 billion increase.

This increase in credit from companies with less ability to pay back their debts will quite possibly lead to an ugly market for every group of firms. The three sectors Richmond identified could get there sooner and could fall harder.

NOW WATCH: Watch the Air Force drop 8 armoured Humvees out of a plane from 5,000 feet

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at