## ch2

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### Definitions and measurement
- Debt-at-risk: debt at firms with an interest coverage ratio (ICR)—the ratio of earnings before interest and taxes to interest—below 1.
- Speculative-grade debt: debt at firms with implied speculative-grade ratings based on ICR and net debt to assets.
- Speculative-grade category in the analysis: all firms in the data set with an ICR less than 4.1 and a net debt-to-assets ratio greater than 0.25. Net debt = gross debt minus cash.
- Corporate bond valuation model: uses economic factors, measures of uncertainty, and leverage; see Section 1 of Online Annex 1.1.

### Corporate performance and outlook
- Slower global growth and escalating trade disputes have curtailed expected sales growth, especially in China.
- Corporate earnings forecasts revised down since April 2019; dispersion in analysts’ forecasts (uncertainty) has increased recently in the United States and Europe.
- US firms reported elevated labor and input costs; managers have become more concerned about tariffs.
- Corporate bond spreads are very low by historical standards and appear compressed relative to fundamentals; misalignments are relatively large in the United States and moderate in Europe.
- Declining interest rates have induced outflows from loan mutual funds and inflows into bond funds, further suppressing bond yields.

### Funding conditions, issuance, and debt accumulation
- Global issuance of corporate bonds and syndicated loans has remained robust in 2019, dwarfing equity issuance.
- Relative to GDP, corporate debt has continued to rise in several major economies, particularly the United States, Germany (though from low levels), and Japan.
- The bulk of the recent increase in US corporate debt was funded by leveraged loans and private lending.
- Bank lending standards have broadly eased since 2016 in both the United States and the euro area, though with a modest tightening for small firms in Europe.

### Financial risk-taking and corporate behavior
- Financial risk-taking by US companies in the form of payouts and M&A has increased, in contrast with subdued capital expenditures.
- Payouts—dividends and share buybacks—at US large firms have grown to record high levels in recent quarters; debt-funded payouts have increased since 2017.
- Smaller firms have increasingly used leveraged loans and high-yield bonds to fund payouts.
- M&A volume has surged to record levels in the United States, dominating global M&A; markups on intangibles associated with debt-funded M&A by US large firms have risen significantly.
- Over the first half of 2019, highly leveraged deals accounted for close to 60 percent of LBO activity.
- Earnings add-backs in M&A and LBO deals have reached record highs and can understate the extent of leverage by overstating future earnings.

### Riskiness of lending and nonbank intermediation
- Riskiness of credit allocation rose significantly in major advanced economies from 2016 to 2018, driven in particular by nonbank lenders.
- In Europe, institutional leveraged loan volume has expanded rapidly while covenant protections have weakened.
- In the United States, provision of credit—especially to risky firms—has shifted further to nonbanks; credit quality of new loans continues to deteriorate.
- Significant growth in the nonbank private lending market, which has reached nearly $1 trillion.
- Private debt funds currently hold the largest exposure and dry powder across loans to SMEs; search for yield and competition have led to weaker underwriting and rising leverage.

### Current corporate debt vulnerabilities (levels and cross-country patterns)
- Profitability, interest costs, and debt-to-assets trends since 2009:
  - China: SMEs remain highly profitable, but large firms (including state-owned enterprises) have relatively weak profitability.
  - Europe and Japan: profitability is close to median global levels.
  - United States: large firms remain highly profitable; SMEs have weak profitability.
  - Interest costs have broadly declined; wedges in interest costs between large firms and SMEs remain significant in China and the United States.
  - Debt-to-assets ratios have declined in Europe and Japan and more recently in China, but remain elevated at large firms in several countries; debt ratios have risen to record levels at US large firms.
- Debt-at-risk (share of total debt):
  - High in the SME segment in the United States and remains elevated in the United Kingdom and some euro area countries.
  - At large firms has declined to relatively low levels in Japan and the United States but remains elevated in the United Kingdom and, to a lesser extent, in China.
- Estimated share of speculative-grade debt in total corporate sector debt:
  - nearly 50 percent in China and the United States;
  - even higher in Italy, Spain, and the United Kingdom.
- Share of debt-at-risk in total corporate sector debt is above 25 percent in the United Kingdom and the United States.

### Adverse scenario and projected deterioration
- Scenario calibration: the same GDP shock is applied to all countries—at half the average severity of the global financial crisis in terms of declines in GDP growth—while interest rates paid by firms rise to half the level in the global financial crisis.
- Based on the IMF staff corporate bonds valuation model, spreads are projected to widen significantly as corporate fundamentals deteriorate and economic uncertainty rises.
- In the adverse scenario:
  - Debt-at-risk rises quickly as weaker profits and higher interest costs lower ICRs.
  - In France and Spain, debt-at-risk approaches levels seen during previous crises.
  - In China, the United Kingdom, and the United States, debt-at-risk exceeds levels seen in previous crises.
  - Deterioration in China and the United Kingdom is driven mainly by large firms; in France and Spain it is attributable to both large firms and SMEs.
- Aggregate impact across the eight economies analyzed: debt-at-risk would amount to $19 trillion, or nearly 40 percent of total corporate debt, in the adverse scenario in 2021.

### Nonfinancial firms: profitability, interest rates, leverage, and credit quality
- Profitability trends (EBIT to assets, aggregate):
  - Since 2009, profitability has improved at European SMEs, Japanese firms, and US large firms.
- Effective interest rates on corporate debt (Interest to debt, aggregate):
  - Most firms have benefited from easy financial conditions, with little differentiation in costs by firm size in Europe and Japan.
- Leverage: Debt-to-asset ratios (Percent, aggregate):
  - Debt-to-asset ratios have declined in Europe and Japan, but increased at US firms.
- Debt-at-risk and speculative-grade debt (ICR < 1):
  - Debt-at-risk has fallen in the euro area, Japan, and at US large firms but has remained elevated at UK firms and has risen in China and at US SMEs.
  - Shares of speculative-grade debt and debt-at-risk remain significant in China, the United Kingdom, and the United States, but have declined in Japan.
  - In the euro area, credit quality has improved, but the shares of speculative-grade debt are still sizable—mainly because of SMEs.
- Scenario analysis and projected stress:
  - Corporate bond spreads could widen significantly in a stress scenario with weaker growth, higher economic uncertainty, and reduced investor risk appetite.
  - Corporate credit quality is projected to weaken in a stress scenario emulating half the severity of the global financial crisis.
  - The data for 2019 are estimates, and 2021 data are forecasts in the adverse scenario.

### Data sample, coverage, and transmission risks
- Sample composition:
  - about 1.3 million firms from Orbis,
  - 10,000 firms from Capital IQ,
  - 10,000 Chinese firms from WIND.
- Sample coverage (based on aggregate corporate debt from BIS and national sources):
  - at least 44 percent in China,
  - 38 percent in France,
  - 55 percent in Germany,
  - 53 percent in Italy,
  - 51 percent in Japan,
  - 62 percent in Spain,
  - close to 100 percent in the United Kingdom,
  - 39 percent in the United States.
- Panels show outcomes for the overall corporate sector based on an extrapolation of the results for the sample of firms.
- Aggregate corporate debt in France includes intercompany debt.
- The data for 2019 are estimates. E = estimated.
- Financial-sector exposures and transmission risks:
  - In the euro area and China, a large fraction of corporate loans comes from banks; thus, banks have significant exposure to corporate risks.
  - In the United States, bond and institutional leveraged loans holders face weakening credit quality; US regional banks are more exposed to SMEs and risky commercial real estate loans and increasingly buy tranches of syndicated leveraged loans originated by large banks.
  - Nonbank lenders have a different risk profile from banks, and their behavior in a downturn, as well as their impact on credit markets and any implication for banks, have not been tested.
  - In addition to credit exposures, liquidity risks could be higher in a downturn, given that the shares of bonds held by mutual funds and exchange-traded funds, as well as by foreign investors, have risen.
  - Ownership shifts: ownership of US corporate bonds has shifted to investment funds and foreign investors; mutual fund ownership of US corporate bonds has increased more than 150 percent from levels before the global financial crisis.

### Regional summary of concerns
- China:
  - overall corporate debt is very high, and the size of speculative-grade debt is economically significant.
  - Debt-at-risk in China is very sensitive to deteriorations in growth and funding conditions and it surpasses postcrisis crests in the adverse scenario.
  - Assessment complicated by implicit government guarantees and lack of granular exposure data.
- Europe:
  - Progress in deleveraging since the euro area debt crisis has been significant; both aggregate corporate debt and debt-at-risk have declined in major economies.
  - The window for an organic cyclical improvement in credit metrics has likely closed.
  - Sales and profits at large firms in the euro area appear to have weakened more than at their US peers this year.
  - In an adverse scenario, debt-at-risk is estimated to approach crisis levels in France, Spain, and the United Kingdom.
  - Small and medium banks have large exposures to SMEs.
- United States:
  - Solid fundamentals at large firms and easy financial conditions have boosted corporate valuations; financial risk-taking by nonfinancial companies has increased, often funded by debt.
  - Rapid growth in risky leveraged loan and private credit segments is of particular concern.
  - The US SME segment is relatively weak, contributing to elevated speculative-grade debt and debt-at-risk.
  - Banks and nonbank financial institutions highly exposed to corporate paper, leveraged loans, private credit, and SME loans would be susceptible to losses in an adverse scenario and could amplify a downturn by cutting back credit.

### Policy recommendations and priorities
- Address corporate vulnerabilities urgently and reduce policy uncertainty to minimize the likelihood of an adverse scenario.
- Financial regulation and oversight should remain robust and rigorous; consider broadening the regulatory and supervisory perimeter to include nonbank financial intermediaries, as warranted—especially those with large exposures to firms.
- Regulators and supervisors of regional banks should closely monitor and address sizable exposures to potentially vulnerable nonfinancial firms and commercial real estate through adequate risk management, provisioning, and capital buffers.
- Improve disclosures at nonbank financial institutions, including their exposures; enhance transparency in the growing private debt market, including through collection of data on cross-border exposures.
- More countries would benefit from actively using macroprudential tools to increase resilience and to cool down credit growth where it may pose risks to financial stability.
  - Broad-based macroprudential tools (such as countercyclical buffers) should be activated preemptively in countries where economic conditions are still relatively benign or financial conditions are still loose.
  - Where credit developments are a concern in a particular sector, conduct targeted stress tests at banks and consider targeted sectoral capital buffers for banks or increase risk weights on such exposures. Countries may also consider developing prudential tools for highly leveraged firms.
- Reduce potential debt bias in tax systems, which allows firms to deduct at least some interest expenses and thus may encourage excessive corporate borrowing.

*Sources: Bureau van Dijk Orbis; S&P Global Market Intelligence; WIND Information Co.; Bank for International Settlements (BIS); and IMF staff calculations.*

### Section 2 of Online Annex 1.1 for details.

### ch2 - Section 2 of Online Annex 1.1 for details.

### Definitions and measurement
- Debt-at-risk is defined as debt at firms with an interest coverage ratio (ICR)—defined as the ratio of earnings before interest and taxes to interest—below 1.
- Speculative-grade debt is defined as debt at firms with implied speculative-grade ratings based on ICR and net debt to assets.
- The speculative-grade category in the analysis includes debt of all firms in the data set with an ICR less than 4.1 and a net debt-to-assets ratio greater than 0.25. Net debt is gross debt minus cash.
- The corporate bond valuation model uses economic factors, measures of uncertainty, and leverage; see Section 1 of Online Annex 1.1.

### Corporate performance and outlook
- Slower global growth and escalating trade disputes have curbed expected sales growth, especially in China.
- Corporate earnings forecasts have been revised down since April 2019; dispersion in analysts’ forecasts (uncertainty) has increased recently in the United States and Europe.
- US firms reported elevated labor and input costs; managers have become more concerned about tariffs.
- Corporate bond spreads are very low by historical standards and appear compressed relative to fundamentals; misalignments are relatively large in the United States and moderate in Europe.
- Declining interest rates have induced outflows from loan mutual funds and inflows into bond funds, further suppressing bond yields.

### Funding conditions, issuance, and debt accumulation
- Global issuance of corporate bonds and syndicated loans has remained robust in 2019, dwarfing equity issuance.
- Relative to GDP, corporate debt has continued to rise in several major economies, particularly the United States, Germany (though from low levels), and Japan.
- The bulk of the recent increase in US corporate debt was funded by leveraged loans and private lending.
- Bank lending standards have broadly eased since 2016 in both the United States and the euro area, though with a modest tightening for small firms in Europe.

### Financial risk-taking and corporate behavior
- Financial risk-taking by US companies in the form of payouts and M&A has increased, in contrast with subdued capital expenditures.
- Payouts—dividends and share buybacks—at US large firms have grown to record high levels in recent quarters; debt-funded payouts have increased since 2017.
- Smaller firms have increasingly used leveraged loans and high-yield bonds to fund payouts.
- M&A volume has surged to record levels in the United States, dominating global M&A; markups on intangibles associated with debt-funded M&A by US large firms have risen significantly.
- Over the first half of 2019, highly leveraged deals accounted for close to 60 percent of LBO activity.
- Earnings add-backs in M&A and LBO deals have reached record highs and can understate the extent of leverage by overstating future earnings.

### Riskiness of lending and nonbank intermediation
- The riskiness of credit allocation rose significantly in major advanced economies from 2016 to 2018, driven in particular by nonbank lenders.
- In Europe, institutional leveraged loan volume has expanded rapidly while covenant protections have weakened.
- In the United States, provision of credit—especially to risky firms—has shifted further to nonbanks; credit quality of new loans continues to deteriorate.
- Significant growth has occurred in the nonbank private lending market, which has reached nearly $1 trillion.
- Private debt funds currently hold the largest exposure and dry powder across loans to SMEs; search for yield and competition have led to weaker underwriting and rising leverage.

### Current corporate debt vulnerabilities (levels and cross-country patterns)
- Profitability, interest costs, and debt-to-assets trends since 2009:
  - In China, SMEs remain highly profitable, but large firms (including state-owned enterprises) have relatively weak profitability.
  - In Europe and Japan, profitability is close to median global levels.
  - In the United States, large firms remain highly profitable; SMEs have weak profitability.
  - Interest costs have broadly declined; wedges in interest costs between large firms and SMEs remain significant in China and the United States.
  - Debt-to-assets ratios have declined in Europe and Japan and more recently in China, but remain elevated at large firms in several countries; debt ratios have risen to record levels at US large firms.
- Debt-at-risk (share of total debt) is high in the SME segment in the United States and remains elevated in the United Kingdom and some euro area countries.
- Debt-at-risk at large firms has declined to relatively low levels in Japan and the United States but remains elevated in the United Kingdom and, to a lesser extent, in China.
- The estimated share of speculative-grade debt in total corporate sector debt is:
  - nearly 50 percent in China and the United States;
  - even higher in Italy, Spain, and the United Kingdom.
- The share of debt-at-risk in total corporate sector debt is above 25 percent in the United Kingdom and the United States.

### Adverse scenario and projected deterioration
- Scenario calibration: the same GDP shock is applied to all countries—at half the average severity of the global financial crisis in terms of declines in GDP growth—while interest rates paid by firms rise to half the level in the global financial crisis.
- Based on the IMF staff corporate bonds valuation model, spreads are projected to widen significantly as corporate fundamentals deteriorate and economic uncertainty rises.
- In the adverse scenario:
  - Debt-at-risk rises quickly as weaker profits and higher interest costs lower ICRs.
  - In France and Spain, debt-at-risk approaches levels seen during previous crises.
  - In China, the United Kingdom, and the United States, debt-at-risk exceeds levels seen in previous crises.
  - The deterioration in China and the United Kingdom is driven mainly by large firms; in France and Spain it is attributable to both large firms and SMEs.
- Aggregate impact across the eight economies analyzed: debt-at-risk would amount to $19 trillion, or nearly 40 percent of total corporate debt, in the adverse scenario in 2021.

*Section 2 of Online Annex 1.1 for details.*

### 1. Nonfinancial Firms: Profitability

### 1. Nonfinancial Firms: Profitability

### Profitability trends (EBIT to assets, aggregate)
- Since 2009, profitability has improved at European SMEs, Japanese firms, and US large firms.
- Regions mentioned: Euro area, Japan, United Kingdom, United States, China.
- EBIT = earnings before interest and taxes; SME = small and medium-sized enterprise.

### Effective interest rates on corporate debt (Interest to debt, aggregate)
- Most firms have benefited from easy financial conditions, with little differentiation in costs by firm size in Europe and Japan.

### Leverage: Debt-to-asset ratios (Percent, aggregate)
- Debt-to-asset ratios have declined in Europe and Japan, but increased at US firms.

### Debt-at-risk and speculative-grade debt (ICR < 1)
- Debt-at-risk has fallen in the euro area, Japan, and at US large firms but has remained elevated at UK firms and has risen in China and at US SMEs.
- The shares of speculative-grade debt and debt-at-risk remain significant in China, the United Kingdom, and the United States, but have declined in Japan.
- In the euro area, credit quality has improved, but the shares of speculative-grade debt are still sizable—mainly because of SMEs.
- ICR = interest coverage ratio.

### Scenario analysis and projected stress
- Corporate bond spreads could widen significantly in a stress scenario with weaker growth, higher economic uncertainty, and reduced investor risk appetite.
- Corporate credit quality is projected to weaken in a stress scenario emulating half the severity of the global financial crisis.
- The data for 2019 are estimates, and 2021 data are forecasts in the adverse scenario.

### Data sample and coverage (exact figures preserved)
- The sample includes about 1.3 million firms from Orbis, 10,000 firms from Capital IQ, and 10,000 Chinese firms from WIND.
- The sample’s coverage based on aggregate corporate debt from the Bank for International Settlements and national sources is at least 44 percent in China, 38 percent in France, 55 percent in Germany, 53 percent in Italy, 51 percent in Japan, 62 percent in Spain, close to 100 percent in the United Kingdom, and 39 percent in the United States.
- The panels show outcomes for the overall corporate sector based on an extrapolation of the results for the sample of firms.
- Aggregate corporate debt in France includes intercompany debt.
- The data for 2019 are estimates. E = estimated.

### Financial-sector exposures and transmission risks
- In the euro area and China, a large fraction of corporate loans comes from banks; thus, banks have significant exposure to corporate risks.
- In the United States, bond and institutional leveraged loans holders face weakening credit quality; US regional banks are more exposed to SMEs and risky commercial real estate loans and increasingly buy tranches of syndicated leveraged loans originated by large banks.
- Nonbank lenders have a different risk profile from banks, and their behavior in a downturn, as well as their impact on credit markets and any implication for banks, have not been tested.
- In addition to credit exposures, liquidity risks could be higher in a downturn, given that the shares of bonds held by mutual funds and exchange-traded funds, as well as by foreign investors, have risen.
- Ownership shifts: ownership of US corporate bonds has shifted to investment funds and foreign investors; mutual fund ownership of US corporate bonds has increased more than 150 percent from levels before the global financial crisis.

### Regional summary of concerns (text excerpts preserved)
- China: overall corporate debt is very high, and the size of speculative-grade debt is economically significant. Debt-at-risk in China is very sensitive to deteriorations in growth and funding conditions and it surpasses postcrisis crests in the adverse scenario. Assessment is complicated by implicit government guarantees and lack of granular exposure data.
- Europe: progress in deleveraging since the euro area debt crisis has been significant; both aggregate corporate debt and debt-at-risk have declined in major economies. However, the window for an organic cyclical improvement in credit metrics has likely closed. Sales and profits at large firms in the euro area appear to have weakened more than at their US peers this year. In an adverse scenario, the debt-at-risk is estimated to approach crisis levels in France, Spain, and the United Kingdom. Small and medium banks have large exposures to SMEs.
- United States: solid fundamentals at large firms and easy financial conditions have boosted corporate valuations; financial risk-taking by nonfinancial companies has increased, often funded by debt. Rapid growth in risky leveraged loan and private credit segments is of particular concern. The US SME segment is relatively weak, contributing to elevated speculative-grade debt and debt-at-risk. Banks and nonbank financial institutions highly exposed to corporate paper, leveraged loans, private credit, and SME loans would be susceptible to losses in an adverse scenario and could amplify a downturn by cutting back credit.

### Policy recommendations and priorities
- Address corporate vulnerabilities urgently and reduce policy uncertainty to minimize the likelihood of an adverse scenario.
- Financial regulation and oversight should remain robust and rigorous; consider broadening the regulatory and supervisory perimeter to include nonbank financial intermediaries, as warranted—especially those with large exposures to firms.
- Regulators and supervisors of regional banks should closely monitor and address sizable exposures to potentially vulnerable nonfinancial firms and commercial real estate through adequate risk management, provisioning, and capital buffers.
- Improve disclosures at nonbank financial institutions, including their exposures; enhance transparency in the growing private debt market, including through collection of data on cross-border exposures.
- More countries would benefit from actively using macroprudential tools to increase resilience and to cool down credit growth where it may pose risks to financial stability.
  - Broad-based macroprudential tools (such as countercyclical buffers) should be activated preemptively in countries where economic conditions are still relatively benign or financial conditions are still loose.
  - Where credit developments are a concern in a particular sector, conduct targeted stress tests at banks and consider targeted sectoral capital buffers for banks or increase risk weights on such exposures. Countries may also consider developing prudential tools for highly leveraged firms.
- Reduce potential debt bias in tax systems, which allows firms to deduct at least some interest expenses and thus may encourage excessive corporate borrowing.

*Sources: Bureau van Dijk Orbis; S&P Global Market Intelligence; WIND Information Co.; Bank for International Settlements (BIS); and IMF staff calculations.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/ch2.pdf_