Leverage in U.S. corporations is building up. And that has some investors and analysts feeling a bit on edge.
Near-record-low interest rates have made borrowing attractive for companies, which have used much of the money for stock buybacks, dividends and mergers and acquisitions. With many foreign sovereign bonds carrying negative interest rates, U.S. corporate bonds are in high demand from overseas investors. And U.S. investors have been snapping up corporate paper too.
“Companies are exploiting low interest rates and significant appetite from abroad to buy corporate bonds in the U.S.,” says Torsten Slok, chief international economist at Deutsche Bank in New York. “That combination will continue to be an important driver of debt growth.” As of Tuesday the Bank of America Merrill Lynch U.S. Corporate Master index yielded 2.88 percent, compared with 3.39 percent a year earlier. Ten-year Treasuries were yielding 1.46 percent as of Wednesday and 2.48 percent a year earlier.
Total debt of nonfinancial corporations rated by Moody’s Investors Service stood at $5.03 trillion at the end of 2015, up 10.2 percent from a year earlier and 61 percent from five years earlier. Corporate cash holdings totaled $1.64 trillion as of December 31, up 1.4 percent from a year earlier and 41 percent from five years earlier.
“The notable increase in corporate debt has coincided with the sector as a whole still holding significant cash buffers,” says Mohamed El-Erian, chief economic adviser at Munich-based insurer and asset management firm Allianz. “But the allocation of debt and that of freely available cash vary significantly among individual companies.”
In 2015 U.S. companies devoted $404 billion to dividend payouts, $401 billion to M&A activity and $269 billion to share buybacks, according to Moody’s. The use of debt for those purposes may present a problem. “From an economic perspective, you would rather see green-field investment and an expanding assembly line,” Slok says. Corporate investment spending dipped 3.1 percent, to $885 billion, last year. “Companies are reluctant to invest more,” he says. “That’s an important reason why the economic recovery has been so weak.”
The composition of corporate debt has changed over the years, with the amount of corporate bonds outstanding growing faster than the amount of bank loans for the past eight years, according to Deutsche Bank. “Taking debt from banks to corporate bonds has increased companies’ vulnerability to whatever the market thinks at that moment,” Slok says. “Corporations are now more vulnerable to Fed interest rate policy and investor demand.” The old dynamic made the banking sector more vulnerable, as banks were holding an excess of corporate debt. Now the bulk of debt is in the bond market. “It’s just a different vulnerability for the economy,” Slok says. “Once you have a stress in the market, then you could have problems in the economy.”
More muted bank involvement in corporate debt may turn out to be a blessing, however. El-Erian, who is concerned about the debt buildup, says it doesn’t pose a systemic risk to the economy. That’s largely because “it does not threaten the most interconnected segments, such as financial institutions,” he says.
So what is the danger of the debt buildup? For starters, more leverage means more risk. “So, there’s a potential vulnerability to an unforeseen negative event,” says Richard Lane, an analyst at Moody’s in New York. A slowdown in economic growth combined with declining earnings would “quickly expose those companies that have taken their financial engineering too far,” El-Erian says. It’s not just companies that could suffer. Investors who buy riskier corporate debt than they would if interest rates were higher also put themselves at risk. “A macroeconomic deterioration would expose holders of low-quality bonds to the threat of a substantial deterioration in the credit quality of their portfolios,” El-Erian says.
Pavle Sabic, head of market development for corporates at S&P Global Market Intelligence, says the fact that over the past eight years the money supply hasn’t changed that much while corporate debt has soared could spell trouble. That’s because there will be a shortage of cash if many companies move simultaneously to repay their debt, he says.
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