Dormant Debt Volcanoes

Climbing a mountain of debt

Topic: Investments

Alana R. Buckley CPA, CA, CFA

October 15, 2019

Image used with permission: iStock/erhui1979


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Dormant Debt Volcanoes

In a recent Nexus Notes article “Living in a World of Lilliputian Interest Rates”, we spent some time on the rather uninspiring implications for investors of low and negative interest rates. But, what does this era of extremely low rates mean for borrowers?

Low rates have provided an illusion of affordability that has resulted in increased debt loads. This illusion is likely to be tested by a move higher in interest rates – even a minor increase. For the time being, however, borrowers have been given the gift of time to get their affairs in order before they find themselves in an uncomfortable situation.

Debt is cheap and has been for over a decade now. And, when things go on sale, people load up. Indeed, this is exactly what has occurred globally, with people, corporations and countries taking advantage of low borrowing costs and accumulating significant piles of debt. Investors need to keep abreast of where absolute debt levels are, as high debt levels can restrict future borrowing and increase borrowers’ sensitivity to fluctuations in interest rates.

There are some effective charts to demonstrate the recent debt accumulation (see below). Unfortunately, that’s not the whole story. Because rates are so low, debt servicing costs have declined, creating an illusion of affordability to these elevated debt levels. Yet, debt levels are more ominous than investors sometimes think. They are, perhaps, best compared to dormant volcanoes that need to be monitored. Volcanoes are dangerous, but only if they erupt. Those who live close to volcanoes can live in constant fear of an eruption or they can ignore the risk and assume the current calm will continue. Today’s bond investors are mostly in the second camp.

We regularly draw attention to elevated consumer debt levels as a potential risk both internally and with clients. But you’ll likely notice that commentary around elevated debt levels is almost always accompanied by the fact that, at present, servicing costs remain affordable.

People typically don’t think of their mortgage as being $600,000 of debt. Rather, they think of it as costing $2,800 a month. Lower interest rates have meant that the principal amount that can be borrowed (in this case $600,000) has been able to increase, while the monthly payment (the affordability) remains the same.

So, while the absolute level of debt is huge, the cost to maintain it is manageable in most instances. Let’s walk through a couple of examples: U.S. Federal debt, and Canadian consumer debt.

There is no question that absolute debt levels are high and have grown rapidly.

AB-Charts-1

In order to make sense of the data, we need to adjust for the fact that the economy and personal incomes have also grown. To do so, we will divide U.S. Government debt by GDP, and we will divide Canadian consumer credit by consumers’ disposable income.

AB-Charts-2

The ratios remain worryingly high, but not quite as damning as before.

Now, if we factor in the cost of debt, the levels look less troublesome. When it comes to consumer debt, we can do this by looking at the cost of interest alone or interest and principal repayments. In these examples, we will look at only the interest cost(1) for both government and consumer debt. When adjusted for the decline in borrowing costs, the trend in the data has completely changed.

AB-Charts-3

The above examples demonstrate that, despite significant debt accumulation, low rates have kept debt service costs surprisingly affordable.

This leaves two questions to address: 1) is all this borrowing good or bad? and, 2) is this a bubble?

Is it a good thing, or a bad thing? First, we must go back to financial literacy 101 and differentiate between good debt and bad debt. If additional debt is taken on and used productively, such as for a sound investment with good return potential, it can be a useful, albeit somewhat risky tool. If, however, a low cost of capital encourages reckless consumption or malinvestment, it can in fact be dangerous. Examples of the misuse of inexpensive borrowed money include buying a bigger house or a fancier car than you can really afford, destruction of shareholder value, and (more subjectively) reckless government spending. All topics for later blogs!

Bubble or no bubble? The answer is, “it depends”. It depends on what decisions borrowers make and what happens to interest rates. If borrowers acknowledge the risk inherent in high debt levels, debt levels decline, and the economy stays strong, there may be time to get things in order without negative repercussions. But this will also depend on interest rates. If rates begin to rise, there will be an escalation of the focus on debt affordability. This occurred at the end of 2018, when there was an expectation that rates were increasing. But this abated in early 2019. Should rates start to increase again, we will see borrowers come under significant pressure, starting with the most indebted.

But we are not there yet, and interest rates don’t seem to be rising anytime soon. There is still time to reduce debt back to manageable levels. We just need to acknowledge that the volcano exists and hopefully borrowers will take the appropriate steps.

(1) Including principal repayments, the debt service ratio for Canadian consumers is higher and has increased over time from around 12% in 1990 to around 14% today.

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