The Federal Reserve's most recent financial stability report points out high levels of business debt, along with volatile asset valuations and drying credit markets, as notable risks to the economy.

With regard to asset prices, the central bank said that after a precipitous decline in March, "risky asset prices have partially retraced earlier declines," but it noted that uncertainty remains high and markets remain volatile relative to historical norms. This situation suggests that further declines could be coming, particularly in areas where valuations have remained high and where asset values are sensitive to the pace of economic activity. The report noted that, despite recent increases in asset values, excess corporate bond premiums (generally a proxy for the issuer's credit risk) "rose well above its historical median," indicating that beneath all the good news, there's still trouble brewing. Another area of concern is the elevated prices in commercial real estate and in farmland, both of which have maintained unusually high valuations over the past few years. The Fed estimates that as people's incomes dry up and they find themselves unable to make rent or mortgage payments, asset prices could soon be seeing major price drops that will disrupt investments.

The Fed also noted that business debt remains a threat to the country's overall economic stability. Increased borrowing by businesses has been a point of concern for years, and this one is no exception. Even before the pandemic, it said, business debt levels were high relative to either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years. The central bank noted that, at the start of the year, about half of investment-grade debt outstanding was rated in the lowest category of the investment-grade range (triple-B)—near an all-time high. Further, almost $125 billion of nonfinancial investment-grade corporate debt has been downgraded to speculative grade since late February, and expected defaults may rise if the economic outlook and corporate earnings are revised downward. As the economic effects of COVID-19 continue to unfold, the Fed said earnings declines will imply significantly lower interest coverage ratios, which could trigger a sizable increase in firm defaults, triggered by widespread downgrades of bonds to speculative-grade ratings which could lead investors to accelerate their sale possibly generating market dislocation and downward price pressures in a segment of the corporate bond market known to exhibit relatively low liquidity.

While it noted that household debt growth has been slower than business debt, the Fed said that with the pandemic leaving millions without a source of reliable income, personal debt has become another risk factor, especially where it concerns mortgage debt.

Another risk, connected to the previous one, is that banks have issued so many loans over the years. While their capacity to absorb credit losses are at historic highs, recent declines in interest rates and the potential for rising credit losses have weakened the outlook for bank profitability, a key factor in banks’ ability to replenish capital. The report also pointed out that during times of financial stress, banks may be exposed to funding risk, as businesses rapidly and suddenly draw down their existing credit lines to ensure they have access to funds to bridge the uncertainty and general concerns about capital markets.

Further, while banks have been packaging loans into securities such as collateralized loan obligations, lower-than-expected asset valuations and lower long-term interest rates buyers such as insurance companies are exposed to risks stemming from sharp drops in asset prices, elevated issuer leverage, potentially rising defaults in the corporate sector, and funding illiquidity risks.

Rounding things out, the Fed pointed to the availability of funding as another risk to the economy. While lenders ended the year in a strong position, many borrowers have rushed to tap deeper into their lines of credit at once, straining lenders' liquidity as they attempt to keep up with all the demand. While banks have large amounts of liquidity to do so, others, like nonbank mortgage servicers, do not and so have had to rely on other measures, like accessing their own internal reserves. It also warned that "money-like liabilities" prone to bank run-like actions (everyone withdrawing their money at once) stood at about 70 percent of GDP in the fourth quarter 2019 (defined as private short-term debt that can be rapidly withdrawn in times of stress).

The report noted that mutual funds are particularly vulnerable. For instance, while bank loan mutual funds experienced only moderate outflows in the last six months ending in February, since March, total net assets of high-yield bond mutual funds decreased by 16 percent, and bank loan mutual funds decreased by 26 percent.

The Fed said that should the outbreak persist, or have a second wave, then the vulnerabilities discussed in the report could amplify negative shocks to the economy. Risk aversion could increase even further, which could substantially weaken profits and accelerate defaults due to the high levels of debt in the corporate sector, as well as harm the finances of even high-credit score households.