By Harriet Torry and Sam Goldfarb
U.S. corporate debt has ballooned on cheap credit to levels exceeding those prevailing just before the 2008 financial crisis, a potential threat to financial stability, the International Monetary Fund warned in its latest review of the top threats to markets and banks.
High corporate leverage could become problematic as the Federal Reserve raises short-term interest rates, the IMF warned, since higher borrowing costs could hinder the ability of firms to service debts.
While borrowing costs remain low, debt servicing as a proportion of income has risen to its highest level since 2010, raising questions over firms' ability to service their debts, according to the IMF's study of nearly 4,000 U.S. firms accounting for about half of the economywide corporate sector balance sheet.
Companies have added $7.8 trillion of debt and other liabilities since 2010, while issuing $3 trillion of equity, net of buybacks, according to the IMF.
The IMF's message stands in contrast to the one being sent by the corporate bond market, which has been rallying for more than a year now.
In early March, the average spread between junk-rated corporate bond yields and U.S. Treasury yields reached 3.44 percentage points, its lowest point since July 2014, according to Bloomberg Barclays data. It was most recently at 3.92 percentage points, still a very low level by historical standards, indicating that investors don't see the debt as very risky.
Some analysts and investors think the corporate bond market is due for another correction. At the end of last year, the average net debt-to-earnings ratio among junk-rated firms was five times, compared with around three times in the years leading up to the financial crisis, according to BofA Merrill Lynch Global Research.
Wednesday's IMF report said the firms with a larger amount of interest expenses on outstanding debt than current earnings accounts for an already high 10% of corporate assets.
Companies that earn less than twice their interest expense are clustered in the energy, utility and real-estate sectors. They already account for roughly 20% of corporate assets, and that number would climb to 22%, or nearly $4 trillion, if borrowing costs rise further due to what the IMF calls "an unproductive fiscal expansion."
The report reiterated the IMF's call for policy makers to shun protectionist trade policies, a nod to the Trump administration's threats to levy new tariffs against trade partners,
It also called on U.S. officials to "vigilantly monitor increased leverage and deteriorating credit quality."The Trump administration has pledged to boost U.S. economic growth by cutting taxes, spending more on infrastructure and the military, and slashing financial regulation. Details of President Donald Trump's tax and spending proposals are yet to be laid out, but anticipation for a growth friendly agenda helped push stock markets to record highs in March.
While the IMF's latest report said there could be considerable positive effects from a U.S. tax overhaul, the fund warns that firms in a number of cash-constrained sectors would struggle to finance capital spending once inflation, and therefore borrowing costs, start to rise.
The Federal Reserve cut short-term interest rates to near zero in 2008 in a bid to lift the U.S. from a deep recession. Since then, the U.S. central bank has only nudged its benchmark federal-funds rates higher three times, to a range currently between 0.75% and 1%.
Years of cheap credit have helped the U.S. economy to recover, but officials are fearful that ultralow interest rates encourage risk-taking and asset bubbles as investors gorge on cheap debt.
The risks of a corporate debt pileup became evident in recent years as oil prices plunged, spurring a wave of defaults among smaller oil and gas drillers, which had been drawn to the bond market by ultralow interest rates.
From late 2014 to early 2016, bonds backed by many energy companies became toxic to investors and the overall junk bond market endured its worst selloff since the financial crisis, pushing interest-rates higher and making it difficult for companies with poor credit ratings to access needed funds. A bond is generally considered "junk" or "high yield" if it is rated double-B or below by at least two major ratings firms.
Since then, however, oil prices have recovered, and the junk bond market has roared back to life, as investors take comfort from an apparently stable economy and a belief that the most vulnerable energy companies are now in a stronger position after emerging from bankruptcy.
Write to Harriet Torry at firstname.lastname@example.org and Sam Goldfarb at email@example.com
(END) Dow Jones Newswires
April 19, 2017 08:44 ET (12:44 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.