Leave it to corporate financial officers to find themselves addicted to debt. All around the developed world, companies have been rightfully taking advantage of our historically low interest rate environment. However, U.S. corporations in particular, now have the highest debt ratio (calculated by taking total long-term and current debt divided into total assets) among developed economies, according to recently published research from Société Géneralé.
And, why not?! Interest rates have been ridiculously low for years. Taking advantage of the opportunity is smart. Using cheap money to finance everything from capital expenditures to distribution expansion to company mergers and acquisitions is a clever method to increase a company’s value. There’s only one issue… this game of musical finance chairs remains only for as long as the sweet harmony from cheap borrowing remains lower than the projected return on equity. However, central bankers have already warned the global economy, higher rates are coming.
Interest rates are nearly 40% lower than a decade ago (chart above), and the amount of U.S. corporate debt outstanding has expanded over this time close to 40%. These near perfect inversely mirrored metrics are concerning. Even though much of this debt is extremely inexpensive, the big question is what has all this debt been used for? And, is all this debt coming due when rates are 100% or 200% higher?
Not surprisingly, a huge portion of this debt has been allocated to the financing of stock buyback programs. Buyback activity has been a leading driver of higher U.S. stock prices. Assuming that demand for stocks has been unchanged (or even a little less since the Great Recession), a reduction in common stock supply forces a new the market equilibrium price. Stocks like any other market follow the laws of supply and demand. Chief Financial Officers (CFOs), CEOs and other C-Suite management personnel receive a significant portion of their compensation in the form of stock options and stock grants. Using financial engineering schemes, like debt financed stock buybacks, has been a relatively low risk method to drive their stock prices higher.
As interest rates head higher, this dynamic will change. Higher interest rates will mean a higher cost of debt financing, which in turn means higher debt service obligations (assuming that CFOs will want to roll the debt into another issue as the prior one matures). Will companies be able to handle the increased debt service payments? Some will, but many will not. Ultimately, it will depend on increased cash flow from operations. Where is this dramatic increase in free cash flow going to come from? And, is the timing of the debt maturity going to coincide with when a company is able to afford it? It’s possible that companies would have to reissue stock, which would be a market debilitating scenario.
Regardless, European and Japanese corporations have utilized debt much less. Remember that leverage is always a driver of additional risk and volatility. U.S. stocks have an extra risk factor embedded within their financial statements that most investors would be keen to keep a close eye on.