Corporate debt around the world has grown in the wake of the financial crisis and has been encouraged by low interest rates, so should alarm bells be ringing among treasurers?
The Organisation for Economic Co-operation and Development (OECD) is concerned about corporate resilience in this high debt climate but accepts that high leverage does not necessarily suggest disaster is lurking around the corner. Nevertheless, the current conditions, with interest rates beginning to creep upwards and forex risk increasing alongside buoyant asset prices, do increase vulnerability to further economic shocks.
The bond market is one area of concern. In recent years there has been a shift towards bonds in corporate financing alongside a decrease in credit quality. This has led to weaker covenants and low bond ratings. In parallel to this, foreign currency borrowing has also been on the rise. Herein lies the danger that foreign currency denominated bond issuance, perhaps through a foreign subsidiary, increases exposure to exchange rate risk.
These conditions, in combination with the high levels of debt and a new paradigm in interest rates, are perfect for an upset in the balance of debt and corporate stability. So, what can companies do?
In the US, firms are benefiting from a recovery in earnings and cash flow boosted by the recent tax bill. An S&P Global Ratings analysis earlier this year suggested that this was helping companies cope better with debt levels and in some cases even begin to pay down. Since 2016, it seems that earnings may be catching up with debt although one third of the 13,000 companies examined by S&P were still classified as highly leveraged.
Even so, it is expected that overall indebtedness will remain high due to higher borrowing costs and reduced access to funding. The positive backdrop to the credit markets at the outset of the year disappeared amid market volatility. Furthermore, with companies around the globe at or close to the apex of the business cycle, lower liquidity reversals and asset prices remain a major risk suggesting defaults could begin to appear if borrowing conditions tighten.
As always, it is important to look at what the debt is being used to finance within the organisation. The efficiency of capital allocation is critical to ensuring corporate debt is sustainable. Unfortunately, according to the OECD, investment levels continue to be low, suggesting that debt is not being used to help long-term productivity. Indeed, there is a suggestion from some economists that over-indebted firms tend to lose their dynamism and become less competitive. These so-called “zombie” firms not only under-perform, but also drag down other firms and competition in their sector.
Other analysts are less pessimistic. For example, Moody’s Investor Service has produced a snapshot of early 2018 showing the number of high-yield companies in the lower half of its credit grades fell to its lowest since May 2015. Just over 200 companies are in this category, accounting for under 14% of speculative-grade bonds.
A mix of defaults and ratings adjustments saw a fall in the so-called junk bond market. Indeed, Moody’s report that there were corporate ratings showing improvement than firms which defaulted, indicating a positive backdrop and the possibility that the default rate for high-yield bonds may fall further.
Despite this positive view, there was a warning from a major global player recently. People’s Bank of China Governor Zhou Xiaochuan warned that Chinese companies have accrued overly high levels of debt. Speaking in Washington at a Group of 30 seminar, he said that the biggest problem facing the Chinese economy was the fact that corporate debt was too high. While the cost of debt servicing remains low he said that companies must deleverage and strengthen their policies for financial stability.
China’s soaring corporate debt is a concern not only nationally but also for global policymakers and investors. While the recent IMF report upgraded growth prospects for the country, it warned of the threat of growing debt which may be masking the real financial health of some companies. The general lack of fiscal transparency in China, including from policymakers, continues to be a major factor when attempting to examine corporate debt.
All-in-all the condition of global corporate debt is a mixed bag, but it remains an area of concern and 2018 is likely to be a defining year.
Simon Lynch is the owner of Treasury Talent
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