Corporate borrowing remains high, despite fears of a pending recession. Still, post-crisis rules may be mitigating the risks.
If it seems like companies are borrowing more money than ever, that’s because they are. Global corporate debt swelled by just over half to $70.7 trillion from 2008 to 2018, according to a Standard & Poor’s March 2019 report. But debt is one thing, leverage is another. Corporate profits have climbed during a decade of economic recovery and interest rates have mostly fallen, both increasing capacity to pay.
As the global economy finally shows signs of stalling, the question is whether by bending the rules of safe credit, borrowers and lenders have shifted the goalposts in a way that proves dangerous in a downturn. The answer from the trenches is that they have a little, but not enough to catalyze a 2008-style calamity. “You’re seeing a bit of a creep in borrowers’ favor in the terms and length of credits, but not the kind of buildup that could see a rising default rate,” says Steven Oh, global head of credit and fixed income at PineBridge Investments.
Not that there is nothing at all to worry about. The corporate-debt binge has been concentrated in the US, where S&P finds borrowing jumped 41% in 10 years—and even more so in China, where it rose fivefold. Corporate Europe and Japan have either missed the opportunity or resisted the temptation, depending on your viewpoint. Among US industries, information technology has been the most voracious, adding debt at a 23% annual pace from 2010 to 2017, according to Deloitte data. Energy companies, which leveraged up to cash in on the shale boom, are probably the most fragile. That sector balance contrasts markedly with the 1990s and 2000s, when real estate led the charge with dire eventual consequences.
Two types of borrowing have also morphed from exotic to mainstream over the past decade. Leveraged loans, syndicated among investors but not listed on an exchange like bonds, have doubled in volume to some $1.2 trillion, says Ruth Yang, a product strategist for leveraged finance who tracks them for the Fitch rating agency. That’s close to the size of the high-yield bond market. Secondly, wads of borrowed cash are flowing not to capital investment, but into the pockets of shareholders as dividends or buybacks. The value and risks of both these innovations are hotly debated—the more so as most leveraged loans are bundled into collateralized loan obligations (CLOs) that elicit comparison with the mortgage-backed securities that wreaked such havoc in the 2000s.
Mashing the numbers and trends together, Deloitte does find signs of credit deterioration. The top 1,000 US corporations have increased their ratio of debt to earnings before interest costs, taxes, depreciation and amortization (EBITDA) by 0.5 on average. Interest coverage ratios, which measure EBIT against debt payments, shrank from 7.5 to 6.5 between 2007 and 2017. The debt-to-EBITDA ratio fell during past recoveries. Junk-rated companies have accounted for almost one-quarter of the bond market since 2010, up from just under 10% in previous growth periods. “I don’t know how serious it will turn out to be, but usually ability to pay improves during a recovery,” says Patricia Buckley, who oversaw the Deloitte study.
But where Buckley sees risk, others see healthy revving of the corporate engine. Much of the added leverage marketwide stems from solid borrowers jettisoning an outmoded attachment to A credit ratings, says Tony Rodriguez, head of fixed income strategy for US asset manager Nuveen. These days they can raise money nearly as cheaply at BBB, the lowest investment-grade level. “There is greater investor sophistication and comfort around BBB credits,” he says. “It makes economic sense to live in the BBB tier.” Maybe not coincidentally, the slip from A to BBB allows “half a turn,” he says, or 0.5 EBITDA, in extra leverage, the same increase found in the Deloitte study.
Even managements that would rather stay prudent with an A rating may not be able to, as activist investors push them to take on the extra debt and distribute it to shareholders, says Martin Fridson, chief investment officer at bond specialist Lehmann Livian Fridson Advisors. “You used to need an A rating so you could have a prime commercial paper rating,” he says. “Now you’re more scared of an activist’s ad in the Wall Street Journal calling you a dinosaur who cheats shareholders.”
The high-yield bond market has meanwhile shifted toward better-quality credit. The proportion of debt rated BB, near the top of the junk pile, has risen from 38% to 49% since the end of 2006, Fridson says. CCC, the riskiest category, has contracted from 16% to 11%. Investors are shunning the flimsiest borrowers despite the general starvation for yield, says PineBridge’s Oh. “We’re seeing now an unusual stratification of demand,” he says. “You’re not seeing transactions that are CCC out of the gate.” High-yield borrowers have also “done a pretty good job of pushing maturities out,” Fridson notes, lessening the risk of repayment problems if a recession is around the corner.
The explosion of leveraged loans has added one more degree of flexibility for corporate borrowers without threatening financial apocalypse, Fitch’s Yang asserts. The loans are generally constructed with a floating interest rate, which proved attractive to borrowers through what seemed like an endless rate-cutting cycle for the world’s central banks. (The action has shifted back to fixed-rate bonds this year as rates seem about as low as they can go.) The quality of companies in the loan and bond markets is similar. Default rates have been similar too, currently an acceptable 3%.
That all makes the CLOs that bundle leveraged corporate loans “a vastly different organism” from the toxic mortgage-backed securities (MBSs) that led to the 2008 financial crisis, Yang says. For one thing, the MBS market was many times the size—measured in trillions, and still $9 trillion today just in the US, while total CLOs only reached $600 billion this April. More importantly, CLOs aggregate fewer, larger loans in a more transparent fashion. Even in the meltdown of 2007-2008, “CLOs ended up very well,” she says.
Then there is China, which has more of a capital-allocation problem than a debt problem per se, says Omotunde Lawal, head of emerging markets corporate debt at Barings in London. Much of the mushrooming corporate debt there is actually government debt by another name, as it has flowed to state-owned companies with state guarantees and been doled out to massive infrastructure projects.
Private firms have been squeezed for finance since Beijing started reining in the so-called shadow banking system in 2018, while smaller enterprises can be cut off altogether. “The government wants to push more credit to the SME [small and midsize enterprise] side, but the banks are not letting it go through,” Lawal says. “Overall there has been some deleveraging over the past two years.”
There are weaker spots in the world of corporate credit. US energy companies were rocked by the oil price crash of 2014-2016 and never entirely recovered, Fridson says. Nearly 30% of the industry’s junk bonds are trading at distressed levels, with a yield more than 10 percentage points above US Treasury notes, he adds. Ruth Yang is concerned about the mostly invisible direct-lending market. This involves midsized companies raising $200 million to $500 million through private placements—amounts too small to be syndicated and rated by Fitch and its competitors, but big enough to have systemic echoes if enough loans go bust in a contraction.
All in all, corporate financial officers might reasonably conclude they are in a golden age for borrowing. The real problem is how to deploy all the available leverage, with domestic economies softening and globalization caught in trade-war crossfires. “You need to look at how companies are spending what they borrow,” Deloitte’s Buckley says. “They don’t see anything out there they really want to invest in.”