Why Bond Investors Aren't Worried About Corporate America's Rising Debt Load
By Daniel Kruger
U.S. corporate debt has climbed to levels that have coincided with recent recessions. Many analysts and investors are unconcerned.
Even before this week's blockbuster $40 billion bond sale by CVS Health Corp., corporate debt stood at 45% of GDP, a level it last reached in 2008 as the economy was entering a recession, according to Moody's Investors Service.
Some companies with weaker credit quality are finding it easier to access the bond market, and others are skimping on covenants protecting investors. Yet analysts say the differences between the current period and 2008 and 2001 -- when corporate debt rose to similar levels as the U.S. tipped toward contraction -- are more important than any similarities.
Today, signs of economic growth persist, supported by corporate tax cuts and a stimulative budget deal, as well as borrowing costs that remain relatively low by historical standards. That means companies can continue to borrow without creating significant economic risks, according to analysts.
Moody's predicts the economy will grow 2.7% this year and expects the default rate on corporate bonds to drop to 2.2% by year-end from 3.2% in January.
Today's credit conditions are also stronger than in the past because of larger capital buffers held by U.S. banks as part of more stringent regulatory standards, Moody's analysts said.
Banks' bondholdings have shrunk drastically since the financial crisis, in part because of Dodd-Frank banking reforms but also because investors are more willing to buy the securities they underwrite. This signals an improved capacity within the economy to handle the present level of corporate borrowing.
Banks formerly held significant amounts of bonds either as unsold inventory from or with their proprietary trading units. In January 2008, the bond dealers in the Federal Reserve's network of primary dealers who underwrite the U.S. Treasury debt held as much as $279 billion of corporate debt on their balance sheets compared with $24 billion as of last month.
Corporations are in a better position to function with higher debt burdens than in the past, some analysts said.
"The difference this time is really in the debt affordability," said Anne van Praagh, head of credit strategy & research at Moody's Investors Service.
The yield on the 10-year Treasury note, which serves as a benchmark lending rate for companies, has climbed this year, recently hitting a multiyear high of 2.943%, compared with an average rate of 4.63% in 2007. And with credit spreads -- the difference in yield between corporate bonds and Treasury debt -- hovering near multiyear lows, investor demand continues to hold down borrowing costs for most companies.
The lower rates mean that interest payments represent a smaller share of a given company's cash flow, said Peter Strzalkowski, a bond portfolio manager at OppenheimerFunds Inc. Many companies have taken advantage of low longer-term interest-rates to extend the maturities of their debt and don't face an imminent need to repay their loans, he said.
Not every observer is so sanguine about the rise in company debt levels. Such a climb in the late stages of an expansion tends to happen as companies become increasingly likely to pursue strategies intended to boost their stock prices, such as share buybacks, or growth that is no longer happening organically, such as through mergers or acquisitions, said David Ader, chief macro strategist for Informa Financial Intelligence.
Both buybacks and M&A activity are heating up. CVS sold bonds Tuesday to help pay for its acquisition of health insurer Aetna Inc. Qualcomm Inc. has also offered to buy NXP Semiconductors for $44 billion in a deal which could be financed in part by bonds. Other pending deals include United Technologies Corp.'s $23 billion planned purchase of Rockwell Collins and Bayer AG's $57 billion expected acquisition of Monsanto Co.
Yet companies appear to be dodging the most-obvious pitfalls, by doing things like extending their repayment dates, some analysts said.
A rise in outstanding corporate debt late in an expansion tends to coincide with periods of Fed rate increases. Under those conditions, companies with large short-term debts have to refinance when borrowing costs are rising, said Steven Ricchiuto, chief economist at Mizuho Securities USA. As company cash flows get diverted to higher interest payments, less of it becomes available for wages and investment, curbing growth and inflation, he said.
Rising interest costs also "squeezes profitability," leading to slower wage growth, reduced business investment and layoffs, he said. So far for this expansion, "that is not happening."
Write to Daniel Kruger at Daniel.Kruger@wsj.com