Spotlight: Corporate-Debt

Different news sources debate the rise of corporate debt.

Project Syndicate: rising interest rates will affect default rates disproportionately across certain industries and countries

  • Debt capital markets offer large corporations alternatives to bank loans, and high-risk borrowers can get access to ultra-cheap credit
  • Some numbers on the growth of corporate-debt
    • In the decade succeeding the global financial crisis, non-financial corporation debt has grown $29 trillion; value of corporate bonds outstanding have tripled in volume and doubled in share of global GDP
    • 22% of nonfinancial corporate debt in the US comprises junk bonds; another 40% are BBB. So about two-thirds of bonds are from companies at a higher risk of default (particularly US retailers)
    • $1.5 trillion of these bonds will mature each year over the next five years, hinting at high odds of defaults as many corporations face bleak financial futures
    • Two-thirds of the global growth in corporate-debt of the last decade comes from developing countries. Chinese nonfinancial corporate bonds outstanding have risen from $69 billion to $2 trillion
    • Side note: global debt has 225% of world GDP, exceeding the previous record of 213% in 2009
  • If interest rates rise by 200 basis points, it is estimated that 18% of outstanding US energy sector bonds will be at a higher risk of default. Similarly, 25-30% of bonds in emerging markets like China, India and Brazil have been issued by companies at a higher risk of default (having an EBIT/interest expenses ratio of less than 1.5) – this could rise to 40% if interest rates rise by 200 basis points

WaPo: Huge share buybacks have propped up stock prices, funded substantially by unsustainable levels of corporate debt. The new expansion of the corporate bond market increases the risk of a massive sell-off, threatening other credit markets.

  • Journalist Steven Pearlstein argues that corporate-debt is the new household debt that took down the economy a decade ago
  • The Buyback Economy: the current economic boom is driven by financial engineering instead of innovation or productivity growth. He points to few statistics: net payments to shareholders as a percentage of revenues has grown from 4.5% in 2000 to 8.7% in 2017 among S&P 500 non-financials, while capital expenditures amongst the same companies and time period has declined from 6.3% to 5.6%. As an example, the $210 billion that Apple has spent since 2012 on share buybacks is enough to the market capitalizations of the bottom 480 companies of the S&P 500.
  • Pearlstein notes that the net issuance of public stock (new issues minus buybacks, and an indicator of the supply of public shares in American companies) has been a negative $3 trillion. This contraction in supply, coupled with the increased demand for public stocks has driven P/E multiples to 25, well above historic averages.
  • Where corporate-debt comes in
    • A third of share repurchases are made with borrowed money. Outstanding corporate bonds have surged from $2.8 trillion a decade ago to $5.3 trillion this year (including $1.7 trillion issued last year alone – half of which were of unfavorable “junk” or “BBB” credit ratings).
    • The growth of bond ETFs has expanded the accessibility of the corporate bond market to individual investors
    • Daniel Arbess of Xerion Investments estimates that of the largest global corporations, more than a third are highly leveraged (5:1 debt-to-earnings ratio), and one-in-five companies have debt-servicing costs that exceed cash flow.
  • What happens when the music stops?
    • Previously, bond prices were kept stable because the pension funds, insurance companies and mutual funds held them to maturity. However, because their trading (primarily through ETFs) have become more liquid, bond prices could become much more volatile, which may result in a tailspin in the event of a spike in interest rates or defaults causing rapid sell-offs by individual investors.
    • Because of the new record size of the corporate bond market, no one is sure how it will react under uncommon market conditions, or how it could affect other credit markets
    • The global economy is at record debt levels (at a corporate-, state-, household- and investor-level), while interest rates are rising from historic lows
    • The Federal Reserve and central banks are upping interest rates while demand for credit is at record highs, and those heavily indebted will be hit with big interest payments, which may crowd-out other types of spending and therefore cause an economic slow-down

MarketWatch: the debt is fine – forward free cash flow is sufficiently healthy and above U.S. treasuries

  • Sean Darby, chief global equity strategist at Jefferies, asserts that U.S. companies’ ability to cover payments remains healthy thanks to “decent cash flow and corporations’ pricing power”
  • Despite large net debt to equity ratios amongst S&P 500 non-financials, he cites a large majority of these businesses maintain a ratio well below 6 (while credit-rating firms usually consider a score of 5 or above as too high and indicate higher probabilities of debt defaults, although this is industry-dependent)
  • As interest rates rise, the corresponding increases in cost of borrowing and debt servicing will eat into corporate earnings.
  • Darby argues that corporations can offload increases in producer prices to customers due to strong pricing power, and their ability to generate free cash flow remains strong, with record net margins for the S&P 500 at 9.73 in Q1 2018.

The Economist: corporate debt has piled up, decreased in quality and yet is cheap to insure against – all negative indicators

  • Despite the positive corporate earnings reports recently, companies have been taking advantage of cheap and tax deductible interest payments and have loaded up their balance sheets with debt
  • The median corporate-credit rating of the S&P global has dropped to one grade above junk, while quality of bonds in this category has declined: the net leverage ratio for BBB issuers was 1.7 in 2000, compared to 2.9 today

  • Instead of increased returns to reflect greater risks on the bonds, the spread on American corporate bonds are at 20 year lows, partially due to the unfavorable returns on sitting on cash
  • The cost of insuring against bond defaults (measured by the credit-default-swap market) has dropped 40% without a comparable drop in risk

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