God is a Capitalist

Thursday, November 12, 2015

Debt service burden signals downturn

Investors can never have too many omens of disaster and the Bank for International Settlements has given us a new one to watch for signs of impending recessions - the corporate debt service burden.

Authors Mathias Drehmann and Mikael Juselius first wrote about it in their article "Do debt service costs affect macroeconomic and financial stability?" published in the BIS Quarterly Review September 2012. They summarized their findings this way:

"We find that the DSR prior to economic slumps is related to the size of the subsequent output losses. Moreover, the DSR provides a very accurate early warning signal of impending systemic banking crises at horizons of up to one to two years in advance."
You can find the latest BIS data on debt service ratios for many countries on the BIS web site here. Here is a graph of the latest data:

The line shows the debt service ratio for non-financial corporations while the bars show recessions as dated by the National Bureau of Economic Research. The BIS data only goes back to 1999 so we have only two recessions to compare, but it appears that recessions might strike before the ratio hits its peak. The ratio has already turned up sharply though it's not clear how high it must rise before it becomes a problem. 

The debt service ratio can rise because sales are flat while debt rises, and we know that corporate debt has risen sharply recently because companies are borrowing to buy back their stock. Or it might climb because debt remains stable while sales fall and we have seen plummeting sales in heavy equipment producers, like Caterpillar, the oil industry, and retail sales giants like Walmart and Macy's. 

Another reason for a rise can be higher interest rates if businesses have borrowed money using variable rates. Should the Fed raise rates in December, the debt service ratio could rise proportionately. 

The BIS researchers found that the debt service ratio is more accurate than the popular debt to GDP ratio. The latter is popular because the data is easy to find while the BIS does a lot of work to create its ratio. Investors need to be aware of where the economy resides in the business cycle because the stock market usually crashes before economists can identify a recession. The BIS provides us with one more tool for navigating the cycle. 

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