The end of the debt bias is nigh

Corporate bondholders, beware. The wave of enthusiasm for this asset class, which has helped it to reach new heights, is now ebbing. A research paper recently published by the IMF illustrates the reasons behind this – although it must be said the paper does not represent the official position of the IMF.

In many countries, companies can get tax relief for interest payments made on debt, which effectively amounts to a government subsidy for firms that take on debt. By contrast, dividend payments do not benefit from the relief.

This could be justified, up to a point. The companies commit to making the regular payments on their debt day in, day out, even when they hardly make any profit or, worse, when they make losses.

By contrast, the payment of dividends is entirely optional and can be cancelled at any moment. Shareholders, after all, know that together with the benefits of ownership comes the responsibility of it.

However, this indirect subsidy for debt from many governments has created a bias towards this form of financing. The IMF research paper, which looked at a cross-country dataset containing 14 million firm-year observations from private company database Orbis, found that debt bias is an important driver of leverage.

The debt bias may explain more than five percentage points of leverage among the sample of companies analysed, according to the paper.

“Thus, allowing for interest deductibility unambiguously increases nonfinancial corporate leverage. Public policies aimed at decreasing corporate vulnerability by containing leverage should therefore consider addressing debt bias.”

Defenders of debt financing argue that, for many companies, this is the only form of financing they can get – especially for small and medium-size firms. It is expensive to issue equity and besides, management in many cases in the past issued new shares when they believed they were overvalued — which is partly why they’re not always received with open arms by the markets.

However, the financial crisis of more than a decade ago has shown how bad leverage can be. The world is still dealing with its consequences. Action taken by central banks to lower interest rates and buy assets to encourage risk-taking has made this problem worse, as the chart below, published in the IMF paper, illustrates.

Corporate debt in the UK, US, Netherlands, France, Canada

Corporate debt has increased since the financial crisis. Source: IMF research paper.

Corporate debt has increased since the financial crisis and poses several risks. Besides the fact that debt-laden companies are reluctant to invest and take risks, with interest rates on the up, the danger of default has increased.

Nonperforming loans could rise and spread throughout the banking system, and in extreme cases could even cause banks to need more capital or even be bailed out by taxpayers again.

In emerging markets, “a substantial part of corporate leverage is in the form of foreign currency debt, bringing exchange rate and cross-country contagion risks to the fore, especially at a time of monetary policy normalization in advanced economies,” the research paper published by the IMF warns.

Even though at this point this issue is confined to a research paper, the fact that it is being discussed more and more (the paper quotes a few others on roughly the same theme) indicates that support for corporate debt as a source of capital is beginning to wane.

If governments start removing the advantages that debt has over equity, we could see fewer corporate bonds being issued. This could be beneficial in the short term for some bondholders, as it would maintain the prices of existing bonds at higher levels.

But over the longer term, it would force investors to rethink their strategies and to allocate more of their capital to equity. While this would be a breath of fresh air for the economy as it would allow companies to pursue more courageous investment opportunities, it would be riskier for investors.