The sharp tick-up of corporate debt should sound a warning to investors: The increasing returns they are currently enjoying are coming from the stretching of balance sheets, and not from genuine growth of their investments.
History, as every schoolboy knows, often repeats itself. That is frequently the case with U.S. corporations, which has added significantly to their debts over the past three years(Crooks, 2014). Take a company like ADP as a good example. The company is an albatross that dominates payroll processing and healthcare contribution business in America. Both its current and future returns look impressive. Yet the company’s management is levering up its balance sheet by adding more debt relative to equity irrespective of the fact that it is highly favored by its industry – an industry that demands massive economies of scale and a reputation sufficient to pacify nervous human resources department and the ever-more-stern and intrusive regulators(Economist, 2014).
Yet, if the experience of the past two years teaches us anything, it is that increase in leverage is one of the factors that intensified the effects of the 2007-2008 recession. When firms add more debt relative to equity, they become more risky to the investors. Unfortunately, the ADP is not the only U.S. firm that is levering up its balance sheet. Cisco and Time Warner, among others, also issued new debts in 2014 mainly to increase their leverage (Team, 2014; Economist, 2014). In most cases, the affected companies apply the proceeds from issuing debts (or bonds) to pay for share buybacks. Hence, it is not surprising that debt issued by creditworthy firms in U.S. had increased significantly. In some cases, they can be as much as 3 times larger than the affected company’s EBITDA – a measure of profit – from about 2 times three years ago.
The quest for liquidity
A number of reasons explain why U.S. companies are increasing their borrowing. First, interest rate (that is, the cost of borrowing money) is low, implying that companies can obtain funds cheaply. With easy access to cheap funds, these companies can take advantage of business opportunities which may result to high returns to the shareholders. In addition to that, it is highly possible that interest rates may eventually rise in the coming years, even to astronomical levels. This simple fact can also be a good incentive for U.S. companies to lock in low rates while they can.
Another obvious reason why U.S. firms are adding more debt can be explained by the resurgence of activist investors – mainly the institutional investors such as mutual and pension funds. Emboldened by a benign economic environment, these activist investors are pushing U.S. listed firms to return more cash to the shareholders. Thus, almost every week there’s an announcement of either a hedge fund or a pension fund pushing a company to buy back shares, for the simple reason that a larger buyer in the market may temporarily push up the price of a stock (Economist, 2014).
The third driver of high leverage among U.S. firms is tax. In this case, the affected companies behave in ways that its management deems will decrease their tax liability. This form of behavior follows a familiar approach: The company issues debt to fund dividends or buy-backs rather than repatriating cash held overseas that would trigger large tax payments. Besides this, debts itself offers tax benefits. For instance, interest payments on bonds or commercial papers are tax deductible and can push down the affected company’s taxable earnings.
How much is too much?
By using more leverage, U.S. firms can reduce the structural disadvantage they have in competing private equity firms and some partnerships with similar structures that pay little or no taxes. The abundance of cheap credit is thus fueling a boom of buy-outs irrespective of the fact that the credit ratings of the new, combined entities may be lowered by the rating agencies. One important fact to note here is that while the underlying cash flow of big U.S. corporations has been growing at a mere 2-5 percent annually, corporate debt, in contrast is growing at an alarming rate, which is in excess of approximately 10 percent per year(Economist, 2014). The bottom line here is that this sharp tick-up of corporate debt should sound a warning to investors: The increasing returns they are currently enjoying are coming from the stretching of balance sheets, and not from genuine growth of their investments. In any case, no growth and heavy debt is always a toxic combination.
Crooks E. (2014): Debt Grows At Biggest U.S. Groups. Financial Times. Retrieved July 10, 2014 from http://www.ft.com/cms/s/0/4f6b9d9a-c300-11e3-94e0-00144feabdc0.html#axzz35TGWvlAj
Economist (2014): American Finance. Retrieved July 10, 2014 from http://www.economist.com/news/finance-and-economics/21603020-crisis-induced-fear-fades-companies-take-more-leverage-risk
Team T.(2014): Cisco’s $8 Billion Debt Sale Bolsters U.S. Cash While Adding Value Through Share buybacks. Forbes. Retrieved July 10, 2014 from http://www.forbes.com/sites/greatspeculations/2014/02/27/ciscos-8-billio…