Debt Gone Wild

Corporate borrowing continues to reach new highs.

Carnival Cruise Lines issued billions in new debt as its ships idled during lockdown; now, the company is ready for tourism’s recovery.

In 2019, corporate borrowing in the United States reached $10 trillion, prompting alarms from the Federal Reserve and the International Monetary Fund. Despite those warnings, borrowing surged during the pandemic last year and has climbed even higher this year. But now concern over the level of corporate borrowing is mostly muted. What’s changed the outlook?

Although US corporate debt issuance keeps growing—reaching another $958.4 billion in the first five months of the year—bankers and economists are being reassured by the rebound in business activity after the pandemic and the fact that many companies are sitting on larger cash reserves rather than spending the money.

“The total amount of debt looks pretty high compared to GDP, but a lot of the debt issuance that happened under Covid-19 was largely used to build up cash balances,” says Jesse Edgerton, a senior economist at J.P. Morgan. “If you look at levels of debt or leverage net of those cash holdings, they look a lot less elevated and are in the middle of their historical average.”

Another factor easing concerns is that there were fewer bankruptcies during the pandemic than expected, thanks primarily to government intervention: The Federal Reserve created $7 trillion to counteract the effects of the demand slump. As a result, many large companies have emerged stronger, with economic growth in the first quarter of 2021 hitting an annualized rate of 6.4%, the second highest growth rate since 2003.

Outside of the US, the picture is similar. In Europe, for example, corporate debt issuance boomed to $368 billion in the second quarter of 2020, a rise of 27% over the first quarter as companies shored up their balance sheets. In the first quarter of 2021, companies issued another $283 billion of bonds. The European Central Bank committed to buying $2.2 trillion in bonds through March 2022 as part of its efforts to support the economy during the pandemic.

“Rates are low, carrying costs of debt are low, and we’re coming out of the pandemic and economic indicators are quite strong,” says Gregg Lemos-Stein, head of analytics and research at S&P Global Ratings.

One reason frequently cited for so much continued borrowing is the low cost of money: The yields on Treasury one-year, two-year and five-year debt are still below 1%. So even companies with large cash hoards, such as Apple, which held $36 billion of cash on its balance sheet and $160 billion of marketable securities as of December 31, 2020, nonetheless issued bonds totaling $14 billion in February. Likewise, Amazon, which held $73 billion in cash and equivalents at the end of March, sold $18.5 billion in new debt in May.

One reason multinationals borrow when they are cash rich is that they are rolling over higher-cost existing debt at lower rates. For example, toymaker Mattel issued $1.2 billion of new debt, which CFO Anthony DiSilvestro said in a first-quarter earnings call would help “generate significant interest expense savings.” Thanks to a credit ratings upgrade after the pandemic, DiSilvestro said, the company will save $40 million a year by replacing bonds yielding 6.8% with new bonds priced between 3.4% and 3.7%.

Another common reason for borrowing is that some companies prefer to keep profits overseas rather than repatriate them to the US; and those funds, while showing as cash on the books, can’t be used for things like buying back shares.

Some companies are issuing new debt out of concern that inflation might drive interest rates higher soon; so they feel it is better to borrow now, when borrowing is cheap, even though they might not need the money immediately. Inflation in the US surged to 3.6% in April from a year earlier, a 13-year high, prompting the Fed to move the timetable for a rate hike up to 2023.

Mark Lynagh, co-head of Debt Markets EMEA at French bank BNP Paribas, says some companies are opting for longer-dated debt, rates that have gone up only slightly and remain low by historical standards. “We’re seeing quite a few borrowers actually buying back shorter-dated bonds and issuing longer-dated bonds, switching their debt profile,” Lynagh says. “The cost of refinancing debt is unbelievably low today.”

One of the key factors fueling the continued bond issuance is the huge liquidity in the bond market, with investors seeking higher yields. This was true for not only investment-grade rated debt, but also high yield bonds issued by companies with lower credit ratings because of existing high leverage or poor business outlook.

Carnival Cruise Lines, for example, issued $22 billion in new debt in the past year, finding willing investors even though its ships were idled in port for more than a year by the pandemic. The bonds issued early in 2020 carried an 11.5% interest rate; so investors made huge profits as the yield on the debt dropped to just 4%, sending the price of the bonds soaring.

While some companies were able to issue high-yield bonds below the 5% interest rate benchmark, they often had to accept shorter terms than investment-grade issuers, opting for five-year instead of the 15-and 30-year bonds being issued by higher rated companies.

Some of the high-yield debt being issued is for highly speculative investments. A company called MicroStrategy issued $500 million of debt June 14 to use for the purchase of bitcoins. The cryptocurrency peaked at $63,503 in mid-April but fell below $30,000 after China banned companies from mining digital currencies.

S&P’s Lemos-Stein says the default rate surged to 6% in the pandemic but never came close to the 10% default rate seen in the financial crisis of 2008-2009. “That is because of the massive amounts of (government) stimulus that flooded the market and enabled companies to take on liquidity or refinance and weather through 15 months.”

Another indication of the health of the bond market was the decision by Fitch Ratings to reduce its forecast for corporate defaults for 2021 to 1% from 2%. Fitch says the change resulted from “increased capital market confidence as constricted sectors in the economy reopen, which led to robust issuance and resulted in enhanced liquidity and pushed out maturities.” In 2020, Fitch said $104.4 billion in investment-grade debt was downgraded to junk status because of the pandemic; but that amount declined to just $2.6 billion this year.

While most analysts remain optimistic about the speed of the economic recovery and the safety of all this new debt, such high levels of indebtedness could cause problems if, for example, the economy should suddenly turn down or a new variant of Covid-19 causes new lockdowns.

J.P. Morgan’s Edgerton, for example, noted that while company cash holdings in aggregate were offsetting risks from indebtedness, some individual firms have taken on large debts and have not built up their cash balances. “We continue to think shocks to the economy could be amplified by current levels of corporate debt,” he says; but he added that the resilience of the corporate sector so far makes him less worried “that current corporate debt levels pose a significant risk to the expansion.”