A Huge Amount of Corporate Debt Might Not Be Ok for Society and Investors
By Raphaele Chappe, Chief Economist & Co-Founding Partner
Should we worry that non-financial corporate debt is at a historic high (both in absolute terms and relative to GDP)? Though in theory financial vulnerabilities should be of concern, there are reasons to think that alarm bells may not be ringing quite yet. In a recent opinion brief, Robert Armstrong has recently looked at this issue, and come out not “terribly inclined” to put corporate debt on his list of pressing worries.
As a starting point, consider that non-financial corporate debt is low relative to the market value of corporate equities. Hans Mikkelsen, credit strategist with Bank of America, has highlighted that the ratio is currently at 25%, at the low end of the historical range. This leads him to some comfort that leverage ratios are not concerning given that “U.S. corporate bond investors have never been backed by more equity value”. Of course, this might simply indicate that stock prices have risen faster than levels of debt, which is, as Armstrong points out, hardly reassuring.
Furthermore, these high valuations are not driven by a few stocks in a top-heavy market. Armstrong points to the stability of the distribution of price/earnings ratios (the mean is at a historic high, but so is the median) as an indication that “the market is now expensive everywhere.” This is not surprising. Valuations are increasingly driven by the liquidity injected by central banks. Research analyzing the macroeconomic effects of large-scale asset purchases launched by the Federal Reserve and the Bank of England in 2008 found a significant and persistent positive impact on overall stock prices; the Fed has since doubled down on asset purchases in response to the Covid-19 pandemic, primarily in order to absorb selling pressures in dysfunctional Treasury and MBS markets (corporate bonds were also included in the facilities). These interventions have led to both a compression of interest rates across the credit spectrum, and a compression of the equity risk premium, fueling both high leverage in the system and asset prices in equity markets. Both the Bank of International Settlements and the International Monetary Fund found signs of a mispricing of risk in both debt and equity markets, resulting in inflated valuations. In November 2020, Société Générale analysts estimated that without QE, the Nasdaq-100 and the S&P 500 should be closer to 50 percent of their value.
There is some comfort in the fact that relative to the book value of equity, leverage ratios are at a 30-year average, as Armstrong points out. Yet balance sheet solvency is one thing; liquidity risk is another. A firm’s ability to meet its liquidity needs and pay off liabilities when they come due depends on its access to capital markets, as well as the availability of liquid assets to cover short-term obligations. Even when the book value of its assets is greater than its liabilities, a firm could still be at risk of defaulting on near-term debt obligations if it is unable to access funding at an acceptable rate and within a reasonable timeframe, or if it does not have enough liquid assets on hand. In the words of Perry Mehrling, quoted here, “a lack of liquidity kills you quick”. As such, we should arguably also be looking at various measures of liquidity risk (such as interest-coverage ratios, current ratios, and others), in addition to balance sheet solvency.
To date, borrowing costs have been kept low, enabling US companies to grasp for cash to survive, borrowing a record US$2.5 trillion in the bond market in 2020. The borrowing frenzy is continuing in 2021. As we document in our paper ESG 2.0: Measuring and Managing Investor Risks Beyond the Enterprise-level, there has been high demand for riskier debt on the part of institutional investors, partly as a result for the search for yield in a low interest rate environment. But with the cost of liquidity distorted by monetary policy, a key source of discipline is being lost in the system, and risk-taking is increasing.
Leading rating agencies are now warning of increased levels of lower-rated issuances that may lead to elevated levels of defaults down the road. According to S&P Global Ratings, sales of speculative-grade debt are on track to surpass all-time borrowing records, having reached $650bn this year already with more than four months left to go in 2021. While many companies on the brink of collapse found the financing to survive, this leaves these firms vulnerable to the slightest future shocks. And while the cost of servicing these increased debt burdens is currently low, this may change. Christina Padgett, head of leveraged finance research and analytics at Moody’s, has opined that “what may be manageable given today’s outlook could be unsustainable in a higher-cost or lower-growth environment”. The concern here is two-fold:
1. Companies with floating-rate debt, as well as issuers with fixed-rate debt scheduled for refinancing are vulnerable to a jump in borrowing costs. For the time being, despite inflation expectations remaining elevated, the S&P500 continues to push higher, and Treasury yields seem to have come down after picking up in early 2021 and peaking in April. But inflation expectations and a broad economic recovery could eventually lead to higher borrowing costs, resulting in excessive debt servicing costs for borrowers with significant debt burdens. A sharp, sudden asset-price correction could also cause a tightening of financial conditions.
2. Companies that have taken on a lot of debt are also more vulnerable to revenue growth slowing down below what was anticipated when that balance sheet was structured.
In our paper, we document various grounds for concern that companies’ ability to pay for the increased leverage is declining, such as credit ratings downgrades, the increase (actual and projected) in US speculative-grade corporate default rates, and in the number of so-called zombie companies (whose interest coverage ratio has been less than one for at least three consecutive years). This leaves us wondering whether the trend of leverage ratios relative to the book value of equity being at a 30-year average warrants a closer examination focused on the distributional structure. For instance, is this the case for most companies, or are there significant outliers? Is there an increase in balance sheet precarity that is somehow not reflected in the mean or median leverage ratios?
Excessive risk-taking can translate into waves of bankruptcies and market instability in the form of credit and liquidity crises. As such, we highlight new forms of systematic risk and macroeconomic instability that may ultimately undermine long-term return goals for investors, particularly Universal Owners with broad exposure to the market as a whole, and question whether current approaches to asset allocation (and in particular the shift to the high end of the risk-return spectrum) are sustainable in the current environment. Moreover, from an ESG perspective, many of these asset classes in the higher end of the risk-return spectrum do not just create risk for investors themselves, but uncompensated risk for other stakeholders. For instance, elevated debt burdens may encourage companies to cut costs, resulting in fewer quality jobs and a deterioration in the quality and affordability of goods and services (e.g. housing, essential healthcare services, or access to infrastructure).
High leverage is arguably making our economy more vulnerable to a solvency crisis in the event of a persistent increase in interest rates and/or should future increases in inflation prove difficult to control. It is also contributing to and compounding the various forms of systemic inequality trickling down to individuals and communities. This is why we are concerned that if the source of high returns for investors lies in leverage rather than fundamental factors, heavy portfolio allocations to certain securities in such asset classes (e.g. high yield bonds, collateralized loan obligations, leveraged buyout private equity) end up creating negative externalities that can systematically undermine institutional investors’ ESG and stewardship efforts. We are working to support investors in their efforts to come to grasp and manage these issues, particularly in aligning investment governance and activities of analysts and portfolio managers with long-term stewardship and return goals for society and investors.