Companies are suffering from a severe debt hangover

II went It’s been a nervous few months for Western economies. The first was a nerve-wracking crisis in the banking sector. Then a still unresolved prospect arose. default by the U.S. government About debt that should be risk-free. Many people now worry about what other hidden dangers lie ahead.

A natural concern is that low interest rates have left non-financial companies heavily indebted in recent decades. Since 2000, US and European non-financial corporate debt has increased from $12.7 trillion to $38.1 trillion, rising from 68% to 90% of that total. GDP. The good news is that strong profits and fixed-rate debt mean that the chances of a corporate debt catastrophe in the West remain reassuringly low for now. The bad news is that companies will soon find themselves in a painful situation. debt hangover It will constrain their choices for years to come.

The Western corporate debt pile has so far proven to be less precarious than many feared. On both sides of the Atlantic, about a third of debt covered by credit rating agencies is considered speculative grade, less philanthropicly known as junk, and repayment prospects uncertain. Default rates for these debts remain at a comfortable 3% in both the US and Europe (see Figure 1). The surge in downgrades from more reassuring investment grade to speculative grade during the pandemic has since been largely reversed.

There are two explanations for resilience. First, corporate earnings exceeded expectations.according to economistcalculated that US and European public non-financial companies’ earnings before interest, taxes, depreciation and amortization increased by 32% in the final quarter of 2022 compared to the same period in 2019. Part of that is thanks to huge profits in 2019. Energy industry, but not all. From fast-food chain McDonald’s to automaker Ford, earnings for the first quarter of this year slightly beat analyst expectations. Consumer goods giants like Procter & Gamble have been able to protect their profits in the face of cost inflation by raising prices and cutting costs. So you have enough money left over to continue paying interest.

The second factor is the structure of corporate debt. Bank of America’s Savita Subramanian points out that in the years following the 2007-2009 financial crisis, many companies began opting for long-term, fixed-rate debt. Three-quarters of non-financial corporate debt in the US and Europe now has fixed interest rates, she said. S.&p A global rating agency. With interest rates hitting record lows in the midst of the pandemic, it created an opportunity to lock in low-interest debt for many years. Over the next three years, only a quarter of the combined debt pile of US and European companies will mature (see Figure 2). The average coupon rate actually paid by issuers on U.S. investment-grade corporate bonds is currently 3.9%, well below the 5.3% yield currently priced in by the market (see Exhibit 3). For high-yield speculative bonds, the average coupon rate is 5.9% compared to the market yield of 8.4%.

morning after

comforting. But companies and their investors would be wise to take less comfort. GDP Growth in the US and Europe continues to slow. Combined quarterly profits for U.S. and European public nonfinancial companies fell in the first quarter of this year, analyst estimates said. The Fed and its European nations are still raising rates. On April 3, American label maker Multicolor Corporation issued a $300 million corporate bond with a high coupon of 9.5%. Companies such as cruise ship operator Carnival have used the financial buffers they built up during the pandemic to delay refinancing at high interest rates. Eggs in such nests are steadily declining.

The burden will start at the most precarious part of the debt.Less than half of speculative-grade bonds in the US and Europe have fixed interest rates, according to S.&P. Globally, it accounts for five-sixths of investment grade bonds. The average coupon on speculative-grade floating-rate loans in the U.S. has already risen to 8.4% from 4.8% a year ago, according to bank Goldman Sachs.

Floating rate debt tends to be prevalent among the most indebted companies, leaving debt-hungry private equity (PE).somewhat PE Funds are hedging rising interest rates, but the pressure has already begun.bankruptcy of PEU.S.-owned companies are so far on track twice as fast as they were last year, according to the company. S.&p global. On May 14, Envision Healthcare, which provides doctors to hospitals, declared bankruptcy. KKRThe private equity giant paid out $10 billion for its business in 2018, including debt. $3.5 billion of equity investment is expected to be lost.

This will be uncomfortable for pension funds, insurance companies and charities that entrust governments with money. PE Barons, not to mention the financiers themselves. Fortunately, the broader economic impact is likely to be contained. PEIn the U.S., aided companies employed about 12 million workers last year, according to the report. EY, a professional services company. Listed companies employ 41 million people.

In fact, the most significant impact for both investors and the economy will be the impact of higher interest rates on large publicly traded companies whose debt is mostly investment grade.of S.&P. The 500 index of large US companies accounts for 70% of employment, 76% of capital investment and 83% of market capitalization of all listed companies in the country.Equivalent stocks The European 600 index has similar weights in its region.

In the years before the pandemic, the nonfinancial companies in these indices consistently spent more cash on capital expenditures and dividends to shareholders than they earned from their operations, with debt filling the gap ( (See Exhibit 4). But if it wants to avoid continued pressure on profitability from rising interest rates, it will need to begin paying down these liabilities soon. At current debt levels, we estimate that about 4% of these companies’ combined profits would be wiped out for each 1% rise in interest rates.

Many companies will be forced to cut dividends or buy back shares, putting pressure on investors’ profits. That would be especially painful in the spiritual heart of shareholder capitalism. The high dividend payout ratio in the U.S., compared to 63% of operating cash flow (41% in Europe), helps boost stocks to earnings relative to other markets. Goldman Sachs’ Lotfi Karooi argues that in a world of high interest rates, borrowing money to give to shareholders suddenly makes no sense.

Many companies will also be forced to reduce their willingness to invest. Semiconductor companies with overcapacity have already cut spending plans. Heavily indebted media giant Disney is cutting investments in streaming services and theme parks. From decarbonization to automation to artificial intelligence, businesses face a costly to-do list over the next decade. They may find that their grand ambitions in such fields are thwarted by the luxuries of the past. This will be bad news for many, not just investors.

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