“This year is unlike anything ever seen in the history of finance.”
After a historic “debt binge,” leverage levels among the 2,200 largest US corporations, excluding financial institutions, have reached “record highs,” Standard and Poor’s warns. It blamed the Fed-fueled “excessive liquidity and low borrowing costs in the capital markets,” along with declining profits.
Now these companies, and “particularly those at the lower end of the credit spectrum,” of which there are more and more, “are as vulnerable to downgrades and defaults as they were in the period leading up to the Great Recession – and perhaps more so.”
S&P Global Ratings sees a clear cause for concern as aggregate debt levels and leverage components that we use to help determine the financial profile of rated companies now exceeds that which we saw just prior to the most recent economic and financial crisis.
The report measures leverage as the ratio of median debt to EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization, a measure of operating cash flow). And that ratio hit the highest level in 10 years.
Junk-rated companies are the most at risk. The credit cycle may have peaked. New financing may become more expensive and harder to come by. And refinancing existing debt may be impossible to do. But these companies’ existence depends on being able to get new financing and to roll over existing debt at super-low interest rates. If they can’t, they’re heading into debt restructuring or bankruptcy – as many have already started to do.
“With the level of leverage that we’re seeing, some of these more-peripheral stressed sectors are going to experience some challenges to obtain new financing as well as refinancing,” S&P analysts David Tesher told Bloomberg.
“It’s not a question of if, it’s a question of when,” he said.
For investors, that translates into potentially big losses in a downturn, which bondholders caught up in the current surge of defaults are already experiencing. And yet, thanks to the Fed-engineered low-yield environment, they’re not being sufficiently compensated for taking these risks.
But what the heck. What matters is today. And today, companies are piling on debt in order to “purchase revenue streams,” as S&P put it. Hence, the record-breaking Merger & Acquisition binge in 2015, including the largest debt-funded buyouts ever.
“Organic revenue growth has been a challenge through this recovery,” Tesher said. So companies are using M&A “to effectively continue their revenue growth.”
Organic revenue growth moves the overall economy forward. But purchasing revenue growth via M&A and then laying off part of the workers to chase after the promised “efficiencies” is a net negative for the economy. And they’re doing it with borrowed money [read… “Shockingly, Boards of Directors Encourage this”: Gallup CEO].
What else have corporations done with this borrowed moolah?
Buying back their own shares. Over the 12 month through June, $157 billion of buybacks were funded with debt, according to data by JPMorgan and Bloomberg. In June, the proportion of share buybacks funded with debt jumped to over 30% – the highest since 2001, the propitious year when the dotcom bubble imploded.
Why borrow? Because operating cash flow doesn’t cover it. In Q2, companies generated $425 billion in operating cash flows. Only $151 billion was invested in fixed assets. The lack of investment is the bane of the US economy. And:
- $110 billion went into dividend payments.
- $61 billion was used for takeovers (OK, that’s down from last year)
- $137 billion was blown on financially engineering their earnings via share buybacks.
So operating cash flows were $35 billion short. That happened quarter after quarter. Hence debt ballooned to 32% of total assets at non-financial firms, the highest since 2008, another propitious year.
Since 2010, companies have blown nearly $3 trillion on share repurchases, according to FactSet data, in order to inflated their share price. But now a snag has appeared. Bloomberg:
Since peaking in February 2015, an S&P 500 index of companies repurchasing the most shares has lost 5.6%, compared with a 1.4% gain in the equal-weight index of the benchmark gauge.
So it doesn’t work anymore. Investors have lost part of their appetite for being fooled.
When rates rise and higher borrowing costs make debt to fund share buybacks more expensive, these already over-indebted companies are likely to cut back. Dividends tend to be sacred for a while, before the company slashes them. But buybacks can be stopped without notice.
“Buybacks have supported equity prices a lot in this cycle,” Dubravko Lakos-Bujas, an equity strategist with JPMorgan, told Bloomberg. But when rates begin to rise, share buybacks are going to decline, and that creates “additional headwinds” for stocks.
It’s already happening: total announced share repurchases fell 18% so far in 2016 from the three-year-average pace.
But the “debt binge” that S&P frets about in its report isn’t over yet. Over the first six days in August, normally part of the sleepy summer months in the credit markets, companies issued a $70 billion of bonds, a blistering pace.
“There has never been an August like this in the history of finance, and it isn’t close,” explained Brian Reynolds, chief market strategist at New Albion Partners, which compiled the data.
The chase for yield, after nearly shutting down earlier this year, has kicked into high gear again, with investors closing their eyes to risks and gobbling up bonds. Their appetite has pushed down yields and compressed yield spreads between corporate and government debt.
“All else being equal, an increase in the supply of new corporate bonds tends to push spreads wider, as was the case with last year’s record-setting flows,” Reynolds told MarketWatch. “The combination of near-record credit flows and significant spread compression means that this year is unlike anything ever seen in the history of finance.”
So to heck with revenues that have been declining since 2014, and earnings, however well engineered, that have been declining for nearly as long, and record debts piling up on these companies, or the soaring risks of defaults, the warnings from S&P and other ratings agencies, or the actual defaults and bankruptcies. Nothing matters anymore – other than the blind confidence that central banks have investors’ back.
But it’s just not helping the real economy, where a peculiar phenomenon has set in. Read… This is When the Jobs “Recovery” Goes KABOOM
Enjoy reading WOLF STREET and want to support it? Using ad blockers – I totally get why – but want to support the site? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.