Corporate debt is too high, and markets are mispricing this

Of all the fears sweeping the markets right now, perhaps the most worrying is the fear of a debt crisis in the corporate sector.

Warnings about corporate debt rising to unsustainable levels are intensifying, at a time when interest rates are at record lows and even Greece joined the club of negative-yield sovereign debt issuers.

The recent collapse of the world’s oldest travel company, Thomas Cook, shows how dangerous high debt can be for a business, despite this incredibly benign interest rate environment.

The company had built up debt worth $2.1 billion because of rapid expansion by acquisition a decade ago. It would have had to sell around 3.0 million holidays per year only to cover the interest payments on this debt, according to Reuters.

Investors are paying attention. The latest survey of fund managers carried out by Bank of America Merrill Lynch at the beginning of October shows that the biggest part of them want businesses to focus on paying down some of their debt.

More precisely, 43% of investors want corporates to spend cash on improving their balance sheets, 39% prefer that they invest in capital expenditures and 14% want companies to return cash to shareholders.

This comes at the same time as the warning in the International Monetary Fund (IMF)’s latest Global Financial Stability Report that debt at risk (money owed by companies whose earnings do not cover interest payments) and speculative-grade debt is already too high in several major economies.

Spreads between the yields of corporate bonds and those of benchmark government bonds of the same maturities are too narrow, because of strong demand from investors.

“According to an IMF staff model, rising corporate debt, weaker economic fundamentals and higher economic uncertainty all imply that spreads should be wider,” the report says.

The United States are the worst offender, while corporate bond spread misalignments are relatively moderate in Europe.

US high yield is more mispriced than European debt

Source of data: IMF. US high yield debt is more mispriced than eurozone high yield debt.

Corporate debt has increased most rapidly in the US, Germany (but from low levels) and Japan. Most of the recent increase in US corporate debt was funded by leveraged loans and private lending, according to the IMF data.

What’s more worrying is that US companies seem to be doing the last thing investors want, if we are to look again at the fund managers survey: firms are taking on debt to increase rewards to their shareholders.

Dividends and share buybacks at big US companies have grown to record high levels in recent quarters and debt-funded payouts have increased since 2017, according to the IMF’s data. Smaller companies have used leveraged loans and high-yield bonds to fund payouts to investors this year.

Debt taken to boost dividends and share buybacks is the worst form of debt. It does not add value to the company, but increases its vulnerability in the case of a rapid change in fortunes. The fact that it is rising is a serious alarm signal.

For the moment, only 31% of the fund managers surveyed by Bank of America Merrill Lynch expect a recession over the next year.

But worries about debt are creeping up, with a bond market bubble and monetary policy impotence tied on the second place in the rankings of investors’ biggest concerns, just behind the trade war.

“Surges in financial risk-taking usually precede economic downturns,” the IMF report warns. If only company managers would heed this warning.

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