Peak Debt Part 3: Corporate debt
Series: Peak debt
A confluence of driving forces nudges the global monetary system toward a reset, with deflation leading the charge.
Part 1 of the peak debt outlines the logic for this phenomenon and examines one of the debt components – household debt starting with mortgage debt.
Part 2 of the peak debt series digs into the auto and student loans component of household debts.
Part 3 of the peak debt series examines the state of corporate debt, how it is used and where it is heading.
In our previous articles exploring the topic of debt, namely peak debt or the inability of individuals, private corporations and sovereign states to take on additional amounts of debt, as the likely leading cause of an eventual reset of our current monetary system (see Deflation, debt and the monetary reset). In Part 1 and Part 2 we covered personal debt including credit card, mortgage, auto and student debts. In this Part 3 of the series we look at debt held by private corporations.
Total US corporate bonds in trillions
The chart above from the US Fed provides a perspective on how much debt corporations have accumulated in past decades. It took the corporate bond market more than 50 years to grow to 3 trillion in size. Then in the short span of about seven years in the wake of the financial crisis, the corporations collectively piled on almost another 3 trillion.
The reason for the corporate debt binge should not be unfamiliar to those who have taken more than a cursory interest in what has been happening to the financial world and monetary policies. In an effort to bail out failing mega banks, ostensibly stopping them from dragging down the entire global economy, central banks all over the world aggressively lowered interest rates to zero (zero interest rate policy or ZIRP) and even negative (negative interest rate policy or NIRP). ZIRP has two direct consequences. Borrowing cost (cost of capital) becomes so ridiculously low that it would be stupid for any corporation not to borrow. Another consequence is that ZIRP turns individual and institutional investors alike into a herd of yield starved lemmings searching for extra yield, in the process ignoring the disproportional amount of risk they are taking on by buying debts issued by questionable companies.
How Was The Borrowed Money Used?
As articulated in our previous article, there are circumstances in which raising debt and leverage make sound business sense. A good example is to use the borrowed money to expand production capacity in anticipation of rising demand. And in a falling interest rate environment, rolling over existing debts at ever lower refinancing rates instead of retiring debts outright also makes financial sense.
Unfortunately, much of the borrowed money has not been put to good use.
At the same time corporations were taking advantage of the ZIRP induced cheap financing, entities like hedge funds, investment banks and other financial entities closest to the monetary spigot borrowed gigantic amounts in low yield currencies such as the Yen and the dollar and invested the proceeds in emerging markets in order to arbitrate the rate differentials (the so-called carry trade). This tidal wave of liquidity washing ashore in those emerging economies invariably resulted in liquidity induced economic booms, driving up financial assets and commodity prices alike.
Confusing liquidity driven financial asset and commodity price inflation with rising demand from an economy with strong fundamental underpinnings, industries from energy, mining to commercial real estate developers borrowed wildly to expand capacity. The resulting overcapacity and a weakening global economy shifted the equation from artificial demand to over-supply. And in the case of crude oil and base metals, the price collapses have been nothing less than spectacular even for such cyclical industries.
Another popular use of corporate debts is leverage buyouts and mergers and acquisitions (M&As). Armed with cheap debt and their own inflated stock prices, corporations unable to grow organically resort to growth by gobbling up competitors at even more inflated prices. While headcount reductions by combining functional teams are always inevitable and almost immediate, the ‘synergy’ so often touted by the merging entities never seems to materialize as advertised.
Financial Engineering and Share Buybacks
In theory, when decision makers of corporations, who have a ground level understanding of their own businesses and the sector they are in, see the true value of their publicly traded company shares mistakenly discounted by the market for whatever reasons, would buy back their own stocks in order to capture the mispriced value at a discount. This sometimes happens at the bottom of a stock bear market when bearish sentiments cause the prices of stocks, good or bad ones, to overshoot to the downside.
In practice, however, the motivation for corporate share buybacks in the past several years has been anything but capturing the price discounts offered by the market, as the ZIRP driven stock markets have risen to almost absurd levels.
Faced with ultra inflated prices, management continues to buy back their own shares for two reasons.
One rational reason is that faced with tepid demand and an uncertain market outlook, the management team sees few reasons to further invest in R&D or expanding production capacity. Rather than plowing earnings into capital expenditures (capex), the company simply disperses the extra cash through stock dividend payouts and/or buybacks their own shares.
A more prevalent reason has to do with the metrics against which companies are measured by Wall Street and how the management’s compensations are structured. Earnings per share, a most common performance metric of a public company, is the ratio of the company’s earnings divided by the total number of shares outstanding. If a company is unable to move the ratio’s top number which is the earnings, one way to cheat is to decrease the bottom number which is the shares outstanding.
Combined with the fact that executive compensations are tied to stock performance and in the form of stock options, there are extremely strong personal incentives to organically grow – or engineer – Wall Street pleasing earnings per share numbers. When the top line looks ugly, slashing the shares outstanding kills two birds with one stone – goose the earnings per share ratio and make more room for extra shares when they exercise their stock options.
Across the board, company executives have demonstrated that they would engage in such financial engineering against the best interest of the company.
So how much have these companies been buying? S&P companies spent a total of over $2 trillion since 2009 repurchasing their own stocks, and have been averaging over $100 billion per quarter or almost half a trillion dollars per year in the past several years, as the chart below from FactSet shows. In fact, public companies repurchasing their stocks have been the sole source of net buyer of stocks in the past years, as other sources such as individual investors, pension funds, mutual funds and ETFs have been net sellers.
S&P 500 Quarterly share buybacks and dividends
Now, one would argue that there is nothing wrong to spend one’s free cash flow generated on stock repurchases when there is nothing worth investing in. Inherently there is no problem with that behavior, unless the total amount spent on buybacks and dividends (cash leaving the company) exceeds that of the free cash one earns from operation, as has been the case in the past two years. How did the companies give out more cash than it generated? By raising debt, of course.
Buybacks and dividends exceed net income
Number of companies with share buybacks exceeding free cash flow
That’s right. Not only did many companies have no money to spend on capex, they would borrow money so it can be spent on buybacks and dividends. That is the behavior of a liquidating enterprise. The management teams knowingly destroy their own balance sheets and load their companies with debt so short term performance metrics can be met and their bonuses are secured.
Where Is This Headed?
So where is this global corporate debt binge headed? Will corporations be soon hitting a debt wall and the onset of peak corporate debt inevitable and imminent? The credit markets are complex and the factors driving both the availability and cost of credit are many. Below is a list of the more prominent driving forces to keep an eye on.
First the tailwinds:
- Interest rates are barely above zero and even negative in some countries. Despite the Federal Reserve jawboning a series of symbolic rate hikes, the ZIRP/NIRP environment will continue to drive investors further along the risk spectrum in search for yield, guaranteeing a steady demand for non-zero yield bonds.
- In their latest round of Quantitative Easing insanity, the ECB is increasing the morphine dosage by including high grade corporate bonds in their monthly purchase program, assuring a guaranteed buyer of debts for some of the corporations.
Now the headwinds:
- Rising defaults – 2015 has seen the highest number of defaults since the 2008/2009 global financial crisis, and so far 2016 is shaping up to be downright ugly (link). The defaults are not contained in the known troubled sectors such as oil and gas and mining/natural resources but are also spread out across many sectors. Rising defaults and the looming recession will greatly diminish investors risk appetite. For high yield/junk rated companies, the bond market can become off-limits to them in a flash when yields spike.
Global corporate defaults
- Souring investor sentiment on buybacks – in recent years companies engaged in share buybacks were cheered and rewarded by investors and Wall Street with higher stock prices. However, there are now growing signs that both are getting weary of such behavior in the face of deteriorating market fundamentals and corporate balance sheets. If corporate executives buy back their company shares in this bloated market for one reason and one reason only and that is to boost stock prices, then the moment the market no longer rewards such behavior, stock repurchases would slow down rapidly.
- Rating downgrades – another limiting factor weighing on corporate CFOs is that further loading up their companies with additional debt would trigger credit rating downgrades from rating agencies, a phenomenon which is already picking up steam as the overall business environment continues to turn sour. For those companies already on the edge, a rate cut often would result in the company completely shut out from the bond market due to punishing rates.
- Maturity wall – slightly over the immediate horizon, there is the maturity wall of existing debt which has yet to enter the conversations within the investment community – the pile of existing debt which will become mature in the next five years and will have to be rolled over. As it stands, there is $9.5 trillion of non-finance corporate debt coming due from 2016 through 2020, according to Bloomberg (link). The ability of corporations to successfully roll over this mountain of debt would largely depend on the state of the global economy, investors’ appetite for risk in the face of ZIRP/NIRP and the specific circumstances of the individual companies at the time. A wrong turn in any of the above resulting in a spike in yields would shut out many of the companies from the credit markets, triggering a death spiral.
Global companies facing debt maturities through 2020 (source: Bloomberg)
- Looming recession
It would be next to impossible to forecast how the scenarios will play out. Regardless of whether the mountain of debt will resolve itself through years if not decades of muddle-through style stagnation or a Nova style debt implosion, it would be fairly safe to bet that the era of companies being able to raise seemingly unlimited amounts of debt is rapidly drawing to a close.
Yellow sticky to equity investors: watch out if and when corporations can no longer afford to buy back their own shares. Barring any central bank buying up stocks using printer money (not impossible in this world of out-of-control monetary policies), these are the only buyers in town. Timing: circa 2016.